The Latest Iron Ore Price Slump: Causes And Effects

Iron ore prices registered their second biggest percentage fall in a single day on Monday when the benchmark price tumbled by 8.3% to close at $104.7 per tonne. This represents an 18-month low for iron ore prices. The price drop came in the wake of disappointing Chinese trade data reported over the weekend. The data showed a steep decline in exports and renewed concerns about a slowing Chinese economy. The other factor spooking the iron ore market is the tightening credit scenario in China which has restricted the ability of steel mills to purchase ore. The fall in iron ore prices is itself acting as a driver for even lower prices because a lot of iron ore has been purchased using financing deals, and financiers are dumping the ore in the market as its value decreases. ^[1]

The mining majors remain unfazed by this decline, claiming that it is a short-term phenomenon and there is no change in their long-term demand projections. Rio Tinto (NYSE:RIO), Vale and BHP Billiton are best placed to ride out this phase since they have lower costs of production compared to other players in the industry due to economies of scale. Smaller companies with higher costs of production may not be so lucky.

See Full Analysis for Rio Tinto Here

What Are The Factors Driving The Price Decline?

1) Disappointing Chinese Trade Data

Trade figures released by the Customs department on Saturday showed that Chinese exports slumped by 18.1% in February, while the market was expecting an increase of around 7.5%. Also, imports rose more than expected. This resulted in a trade deficit of $23 billion against a surplus of $32 billion in January. The data underlined the market’s doubts that China won’t be able to meet its GDP growth target of 7.5% in 2014. The largest end user of iron ore is the steel industry and there is a strong correlation between usage of steel and GDP growth levels.

2) Tightening Of Credit To Steel Mills

The Chinese government has announced that it will limit credit to steel mills which are not performing well. This has limited their ability to buy iron ore, resulting in a demand squeeze for the commodity. The mills are now buying iron ore only when they need to. As a result, iron ore inventories at ports are rising which will limit room for future growth in iron ore imports. This will prevent a rise in prices. In addition, the Chinese government has ordered many steel mills to shut down as part of its crackdown on pollution.

According to a report in the Financial Times, Chinese property developers import copper, zinc, rubber or palm oil just in order to get access to letters of credit, which are used as short-term loans to ensure solvency long enough to make sure that projects enter the market. Some steel mills are now taking to this practice by importing iron ore only to make sure that cash flows continue. According to us, this points to an excess inventory build-up which will preclude further exports for some time and as a result prices will not regain their previous levels in the short-term. ^[2]

3) Financing Deals Caused A Cascading Effect

Many steel mills have purchased iron ore by borrowing money and keeping the commodity as collateral with lending institutions. The decline in prices triggered margin calls and dumping of inventory on the market by lenders in case of failure to meet those calls. This drove down prices further by creating a vicious circle as the market got flooded with iron ore. Else, the magnitude of decline would most likely not have reached 8.3% in a single day. ^[3]

Are Mining Companies Worried?

Although mining majors such as Rio Tinto, Vale and BHP Billiton registered a fall in stock prices, they don’t seem to be worried. Most of these companies claim that they have their eyes on the long term and trends there remain unchanged. Rio and BHP expect steel manufacturing capacity in China to exceed 1 billion tonnes by 2025 or 2030 which will result in a rise in demand for iron ore. The present installed capacity for making steel in China is around 800 million tonnes. ^[4]

However, in the short term, there are likely to be consequences. The price of iron ore averaged $126 in 2013 and Rio stated in February this year that a 10% drop in that figure would erode its underlying earnings by $1.2 billion. BHP also said that each $1 decline in the iron ore price affects its post-tax profits by $120 million. Rio has a break-even price of $43 per tonne of iron ore so the company won’t lose money on whatever it sells, only the amount of gains will be impacted. ^[5]

The outlook for average iron price in 2014 is hazy at the moment. It will depend a lot on policy decisions taken by the Chinese government which can increase or decrease liquidity at whim or decide to be strict or lenient about addition of new steel manufacturing capacity. We will keep a watch on further developments in this space and firm up our view on iron ore prices as the picture becomes clearer. Meanwhile, you can observe the impact of different iron ore pricing scenarios for Rio’s valuation using our interactive graph:

See More at Trefis | View Interactive Institutional Research (Powered by Trefis)

1. Iron ore price plunges on China fears, The Sydney Morning Herald [↩]
2. Storm clouds gather for seaborne iron ore, Financial Times [↩]
3. China slowdown not sole reason for iron ore price plunge, The Sydney Morning Herald [↩]
4. BHP and Rio Tinto upbeat on iron ore prices despite slump, The Sydney Morning Herald [↩]
5. Iron ore slumps after China trade numbers disappoint, Financial Times [↩]