Market Insights: Can Iron's Oresome Rise continue? | BetaShares

Market Insights: Can Iron’s Oresome Rise continue?

BY David Bassanese | 9 March 2016
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This note explores the reasons behind the “oresome”‘ rise in spot iron ore prices in recent months -and assesses whether the rally can last. Contrary to some hopes, the underlying fundamentals regarding iron ore supply and demand do not appear to have changed all that much, suggesting further price upside is limited.

Iron Ore Prices Explode to the Upside

Even with the known volatility in spot iron ore prices, the recent price surge seems quite exceptional. Within the broad trend of decline in prices through 2015, there were two corrective rallies of 38% between April and July, and 30% between July and September.  The recent rebound in prices from a low of $US38.30 on December 11 to a recent high of $US63.75, however,  constitutes a price gain of around 68%, or twice as rapid. On Monday 7 March alone, prices rose by 18.6%! Oresome!

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Why have prices increased?  For starters, after a sharp price decline it is often natural for prices in any actively traded market to pause and stage at least a partial corrective rally – especially if short selling is allowed.  Traders who have been “short” as prices decline see a stabilisation in prices as an opportunity to take profit by “covering” – or buying back – their short positions, which can lead to what’s known as a “short covering rally.”

That said, the sustained rise in iron ore prices over the past few months is clearly more than just a typical short-covering rally. Several more “fundamental” reasons have also been advanced:

  • Australian supply disruptions.  Cyclonic activity around Australia’s (and the world’s)  largest iron ore bulk-loading terminal in Port Hedland disrupted shipments for two days in January, resulting in iron ore exports declining by 10% from December levels. Export shipments were down 8.1% on year-ago levels. Shipments recovered by 8.4% in February, but were still down 2.4% on December levels.
  • Chinese demand rebound. Chinese steel mills have ramped up production in recent weeks following shutdowns associated with the February Lunar New Year break.  This has been reflected in a run-up in iron ore stock piles at Chinese ports to an above-average 95.75 million tonnes, though the inventory build appears to have tapered off in recent weeks.
  • China stimulus.  The Chinese Government’s latest national economic plan has been interpreted as bullish for the iron more market, because of the promise to keep economic growth at 6.5% to 7% this year, and spend more on steel-intensive national infrastructure. This follows on from other Chinese policy easing of late, such as a cut in bank reserve requirements and deposit requirements for those wishing to buy a residential property.
  • Steel prices.  Firmer Chinese steel prices – in part due to a curtailment of over supply – has also encouraged some bidding up in iron ore prices.
  • $US.  A weaker $US dollar in recent weeks, partly due to expectations that the Federal Reserve will postpone raising US interest rates, has also supported commodity prices more broadly, to the extent it makes commodity prices cheaper in non-US currencies.
  • Central bank stimulus. Talk of more stimulus in Japan and Europe – including a potential fall of official interest rates further into negative territory – has also boosted global growth sentiment.

 

The Fundamentals Remain less than Oresome

That said, it seems highly unlikely that iron ore prices can continue to rise for much longer as the more medium-term forces of demand and supply still favour lower prices.

As noted above, Chinese iron ore stock piles have now risen to relatively comfortable levels and this source of near-term demand should soon level off.

And despite the promises of more Government stimulus, the fact remains that China is still suffering from a glut of steel oversupply, due to both an excess of already-built residential properties (especially in more regional second-tier cities) and declining manufacturing export competitiveness due to China’s relatively high real exchange rate (which we analysed here).

According to the World Steel Association, Chinese steel production is expected to fall a further 2.9% this year to 783 million tonnes, after a 2% decline in 2015.  Just because recent supply reductions are encouraging a lift in depressed Chinese steel prices, it does not naturally follow that this should boost iron ore prices also – after all, steel rationalisation still implies falling demand for iron ore inputs.

Further declines in China’s steel production seems likely.  Rio Tinto’s former chief economist, David Humphreys, is quoted by Bloomberg as saying “there’s about 300 million tons of surplus [steel] capacity in China that needs to be not just shut down, it needs to be eradicated, it needs to be bulldozed.”   And ignored by the commodity bulls, even China’s new economic plan announced over the weekend contained a proposal to cut the local coal and steel industry workforce by 1.8 million workers, or 15 per cent, over coming years.

Meanwhile, global iron ore supply is slated to expand further this year, although at least part of this will replace high-cost Chinese iron ore producers belatedly exiting the market.  According to the latest Commodity Outlook by Australia’s Department of Industry, Innovation and Science, Australian and Brazilian iron ore exports are expected to rise by 13.2% and 7.5% respectively this year. Gina Rinehart’s Roy Hill mine started shipments in December, with plans to ship 55 million tonnes of iron ore per year.

The recent weakness in the $US is also likely to prove only temporary, as ongoing strength in the US economy likely means the Fed will have no choice but to raise interest rates further this year. A rising $US will tend to place downward pressure on commodity prices in general.

Last by not least, seen from a much longer-run perspective, moreover, the recent spike higher in iron ore prices does not seem so “oresome” after all.  As with the Chinese stock market, it seems that trading in the sport iron more market can also shift abruptly from fear and greed, leading to exceptional price volatility.

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Sell the Aussie, buy the $USD?

If I’m right, renewed weakness in iron ore prices is likely to placed renewed downward pressure on the Australian dollar and local official interest rates.  Indeed, with the $A pushing above US74c, we have only recently highlighted that those investors with a view that the Australian dollar may be in for fall v. the U.S. dollar may look to do so through the BetaShares US Dollar ETF.

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