Risk is unavoidable in investing so understanding how much you can tolerate is key to long-term returns
The continued over-supply of iron ore to the global market has once again forced City number crunchers to downwardly revise their price forecasts. But it's a single line in a Jefferies research report which really catches my attention. This notes how high-cost Chinese miners are managing to stay afloat despite the falling iron ore price as they appear to be benefiting from reduced costs.
Jefferies says the limited amount of capacity taken offline by Chinese iron ore producers has been 'surprising' and explains why the commodity price has fallen by more than expected. The general resilience of the Chinese players 'implies greater than expected marginal cost deflation in the industry’.
Falling costs would mean traditionally high-cost miners may be able to stay alive for longer while commodity prices fall and before the economics finally catch up and force them to stop production. So anyone assuming the natural progression of the cost curve will soon lead to widespread iron ore mine closures should think again. The players may have been given an extra life in the game and the traditional iron ore cost curve support could be lower than it has been in the past. That implies further downside to iron ore prices, particularly as supply growth is substantial until 2016.
Count the costs
When miners realised they had spent too much on acquisitions that didn't provide an adequate return on capital employed, everyone was quick to revise capital expenditure (capex) plans. At the time, there were comments that mining costs would come down in time, but the market focus has since been on the ability to pay dividends.
Given that capex levels should have reached, or passed, their peak in the industry, cost deflation must surely become a greater focus for those analysing the sector. Mining service companies have been saying for some time that life is harder as there's less work around. The natural law of business would suggest that consultants' pricing would fall, so too the cost of mining equipment as suppliers aren't as flat out as they were during the commodities boom, therefore they've lost pricing power.
Unfortunately there are plenty of indicators to suggest mining costs aren't going to radically fall. Reduced activity should theoretically mean miners are under less pressure to put up wages. Yet the South African mining strike that gripped the platinum sector this year would suggest there's still pressure salary. Energy costs remain high, so too certain currencies such as the Australian dollar which is hurting iron ore and coal miners in that country.
Many logistics contracts are based on the 'take or pay' principle, where miners must pay for port and rail allocation regardless of the quantity of material delivered, so it can make more financial sense to still move material and operate at a small loss. A possible surge in freight rates could trigger major earnings downgrades for iron ore and coal exporters. Supply volumes are growing but there's been five years of declining investment in new vessels.
Some analysts say there's plenty of anecdotal evidence of Chinese iron ore mines closing down, yet this isn't reflected in the latest monthly iron ore production figures.
Jefferies sees numerous reasons why the Asian industry has been more resilient than expected, including:
• The Chinese government is focused on boosting employment, so state-owned mines (half the country's domestic supply source) may still operate at a loss
• Possible Chinese government subsidies for high-cost private mines
• Mine operators are bullish about near-term price recovery so don't want to turn mines off
• Chinese production data is wrong
• Production cuts accelerated in June, but data is not yet available
• New lower-cost production has come online, offsetting high-cost mine closures
• Production costs have fallen, so private operators are not yet feeling enough pain to close mines
Iron ore pricing troubles look set to continue, hence why the market hasn't followed the recommendation of many analysts to buy equities in the space. Indeed, Sierra Leone-based iron ore miner African Minerals (AMI:AIM) has halved in price to 68.25p since we said to steer clear of the stock a mere two months ago (see Under The Bonnet, Shares 10 Apr). Yet to identify a potential bigger threat to the industry, watch the cost figures closely.
If higher-cost miners (of any commodity) can operate for longer than before without being knocked out of the game, there could be some serious downgrades to miners' earnings forecasts as the natural cost curve is rebased and supply forecasts are increased.