FOR decades the iron-ore trade was boring, but stable. Annual contracts, predominantly made between Japanese steelmakers and Australian miners, left little room for the price volatility that plagued other commodities such as oil. Profit margins for iron-ore miners were thin, even if relatively consistent compared to other metals.
This arrangement, however, has been undermined by two consecutive upheavals. First, China’s economic boom sent demand, along with ore prices, soaring. Then, even more abruptly, the global financial crisis caused both to plummet. Yearly contracts proved too inflexible for such volatility and in response a system of spot trading arose. The spot price duly rose, as China's economy continued to prosper. By 2011 spot prices were almost three times higher their mid-recession low. But flexibility cuts both ways; since the start of the year iron-ore prices have fallen by 38% to $83 a tonne, their lowest level since October 2009 (see chart).
While analysts have long forecast a decline in the price of iron ore, the deterioration has been much more rapid than expected. The fall is largely driven by new low-cost supplies being developed in Brazil and Australia. Having invested $89 billion in new capacity over the past five years, the four big miners—Vale, Rio Tinto, BHP Billiton and Fortescue—saw their output grow by 15% in the first half of the year, compared with the same period in 2013.
There are also signs that China’s demand for steel, the prime mover of the iron-ore price in the past, has fallen. Credit restrictions, which were intended to restrain the country's overheating housing sector, which alone accounts for 14% of all steel use in China, have taken a toll. And those restrictions are just one aspect of a broader effort to make China less reliant on investment.
Lower prices should start to force higher-cost producers out of the market. Despite their recent decisions to increase production, the big four miners still have the lowest costs in the industry, at somewhere between $40 and $50 a tonne including transportation costs. The most marginal mines are those in China. These produce lower-grade ore, which is more expensive to refine. It also costs more to transport the ore across China to coastal steel mills, than it does to send it from other places over the Pacific by ship.
While the fall in prices will reduce profits, the big four are likely to keep expanding. Mining projects are usually planned and costed over decades, not quarters, and so far analysts’ projections for the price of iron over the medium term have remained unchanged. Mines are expensive to open and close, and only an even deeper and more lasting reduction in prices would nudge them to start cutting production. Prices would have to fall a further 40% before the big four would consider shuttering any mines.
Indeed, the recent fall in price should be kept in perspective. A decade ago the price for iron ore was only $20 a tonne. Even adjusting for inflation, prices are, even now, triple that level. The iron-ore boom may have come to an end, but the big miners have so far managed to remain profitable.
source: The Economist
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