Is the iron ore rally overdone? – Northern Miner Editorial (January 10, 2013)

The Northern Miner, first published in 1915, during the Cobalt Silver Rush, is considered Canada’s leading authority on the mining industry.

Spot prices for iron ore fines delivered to China touched a three-year low in September 2012 of US$87 per tonne before rebounding to US$119 per tonne in December and to the US$158-US$160 per-tonne level of recent days. The question is, where will prices for the metal move from here?

John Goldsmith, deputy head of equities at investment management firm MontruscoBolton in Toronto, says they have nowhere to go but down. “Iron ore has had an absolutely phenomenal rally but I think it’s time to take money off the table,” he says. “The rally has been long in the tooth.”

In Goldsmith’s view, GDP growth in China over the next three years will average about 6%, down from the 7.8% the country clocked last year and the 9.2% of 2011. That estimate, he explains, is a function of the average 7% GDP growth rate set out in China’s last five-year plan in 2010. And a growth rate of 6%, he says, will have an impact on iron ore demand and prices, given that the economic juggernaut produces nearly 50% of the world’s steel and makes up more than 60% of global demand for seaborne iron ore.

“People are realizing that China will not grow to the moon, it will not have GDP growth north of 8% for the next ten years, and people that think that are dreaming,” he continues. “The risk for the iron ore trade right now is that there is a slowdown in infrastructure spending in China and it will have an impact on steel consumption usage and that will cascade down to the iron ore price.”

Over the last decade, China has undergone the greatest industrialization phase the world has ever seen and consumed more steel than any other country on earth. But that trend won’t continue indefinitely, he reasons. “China has already urbanized more people than any other country in history; it urbanized 200 million people over the last decade and will urbanize another 100 million people over the next decade, so they’re going to use less steel.”

Last year, China produced about 720 million tonnes of steel, and Goldsmith believes that’s more than enough to meet its needs. “In two year’s time are they still going to be consuming 700 million tonnes of steel a year? I think that’s close to maximum capacity.”

Looking at equities, Goldsmith believes that anyone that is not long iron ore should not be looking at taking new positions now. Higher iron ore prices are already priced into the stocks and are unlikely to surpass their all-time high of US$192 per tonne seen in February 2011, he maintains.

As for potential acquisitions of iron ore projects in Canada, he is doubtful, arguing that the big players like BHP Billiton, Rio Tinto and Vale have announced slowdowns in terms of their own growth projects and are able to produce enough of the metal that they would not be interested in buying projects or producers in North America.

M&A also isn’t likely to come from any of the intermediate producers like Cliffs Natural Resources, he argues, because of their distressed balance sheets, while Asian companies have become increasingly shrewd and careful buyers. And if the Asian steel mills were looking to buy iron ore projects, the time to do so was four months ago when iron ore prices were decimated, he believes.

“Where were the POSCOs, where were the Baosteels then?” he muses. “Where were these monstrous steel companies back in September and October when you could buy all these iron ore companies at basically half the price they are today? This time in September it was like the death of iron ore, nobody wanted to talk about it. Now everybody wants to talk about it, and I can’t believe the balance sheets of these steel companies have gotten any better or worse than they were then.”

Jessica Fung, a commodities analyst at BMO Capital Markets in Toronto, forecasts GDP growth in China this year and next will be above 8%. Among other things, the central planners in Beijing realize they need to keep industrial manufacturing activity at a decent level to ensure that people remain employed, she says. And in terms of steel production specifically, the consolidation that the central government has been trying to implement is taking longer than hoped.

At the same time, however, she believes that steel production in China is likely to peak over the next few years. She also forecasts that global demand growth for steel this year will come in below the 3.5% BMO forecasts for global economic growth. As a result, she explains, “we’re not going to see the kind of double-digit growth in seaborne iron ore demand that we have in the past.”

After a period of restocking iron ore inventories at Chinese ports ahead of the annual week-long break at Chinese New Year, which she says was responsible for part of the dramatic run-up in prices recently, she forecasts prices for the metal will normalize in February, averaging about US$120 per tonne in the first half of 2013 and US$130 per tonne in the second half of the year. In 2014 they will remain flat at about US$130 tonne, she predicts, before moving down to roughly US$120 per tonne in 2015 and to US$115 per tonne in 2016.

As for potential acquisitions, Fung doesn’t believe there will be as much enthusiasm for them as there was in the run up to iron ore prices of US$192 per tonne in early 2011. She also notes that Chinese steel mills have been developing relationships over the years with the major suppliers such as Rio Tinto, Vale and BHP and have become comfortable about the quality and consistency of the product. “This is the same process that the Japanese and Korean steel mills went through a couple of decades ago,” Fung explains. “After a while they realized that they could establish very, very, strong, long-term relationships and understand the product and they didn’t need to be out there spending money on infrastructure anymore.”

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