Where's iron ore headed from here?
Here we are once more in the teeth of the great "super-cycle" debate as iron ore probes daily new lows in the reach for a China-Crisis clearing price.
This is my first Livewire post, representing my firm Jevons Global, so I will use this opportunity to frame my contribution to the current debate in a way that helps explain who we are and how we habitually think about market questions such as: "Where to next for iron ore?".
Firstly, it may be a helpful orientation to mention after whom Jevons Global is named. For those who are unfamiliar with the 19th Century, William Stanley Jevons (1835 - 1882) was an English political economist who is credited with ushering in the "marginal revolution" of utility theory. He lived his formative years through a coal-powered and steel-rich industrial revolution and was much occupied with thinking about the price fluctuations of that era.
Jevons was born in Liverpool, England. His father was an iron merchant whose firm failed in one of the periodic steel booms and busts of the Victorian era. That was in 1847, ten years into the long reign of Queen Victoria, at a time when the industry of England led the world economy.
With that introductory parallel, enough of ancient history. The attachment I maintain to William Stanley Jevons is not the time he lived in, but how he thought about prices.
This can be summed up in two words: supply and demand.
Trite in the present context, except for one small detail. The marginal revolution ushered in the modern notions of "marginal cost pricing" and the idea that, in fully competitive markets, the marginal price of one more widget should settle at the marginal cost of production.
This is now second nature to our thinking about markets, but we should know instinctively that a huge assumption lies at the heart of that innocent phrase "fully competitive markets". The question to be answered, in any real situation, is whether the market is or is not so.
Take digital business. The great scalability of the Google search engine derives from the near-zero marginal cost for Alphabet to serve a search query. Due to their domination of eyeballs for search interest, the price Alphabet can charge for advertising is not the marginal cost of serving the query. It is many multiples of that number, and so they earn super-profits in doing so.
Jump now to the present circumstance. The economic heft of China, and state-directed orders to their steelmakers, come pitted in a pitched battle to set a price for iron ore. China is not the only source of demand for iron ore in steelmaking, but as is well-known, they account for as much a 70% of the seaborne trade in iron ore. The bulk of this comes from the Pilbara in Western Australia, with a second source in Brazil, with the largest mine in Carajás.
Set aside for the moment any new sources of supply, such as Simandou in Guinea, located in West Africa. The key point to focus on is that the two sides of this marketplace are of roughly equal heft. The dominant supply out of the Pilbara, and the dominant demand landed at the Western ports of China in Qingdao and Tianjin, largely match one another, with the major swing producer being Brazil and no single dominant swing source of demand.
In such a marketplace, marginal cost pricing does not really mean very much. The last time I looked, iron ore futures were trading around $128 USD a tonne, down from a nosebleed peak of $220 that was struck in July 2021. The three majors of Australian iron ore: BHP Group (ASX: BHP), Fortescue Metals Group (ASX: FMG) and RIO Tinto Limited (ASX: RIO) all posted cash costs of production at between $15 and $20 USD per tonne. Clearly, if the price is set at the margin, those on the margins of iron ore are very marginal.
If we now flip over to China, where there has been much anguish from the central government of the Chinese Communist Party, one might assume that all is hell and pestilence in the steel industry. On the contrary, global steel prices, and Chinese steel prices, are at or near record levels. For instance, the US Mid-West Hot Rolled Coil price is hovering around $2000 USD per ton, having emulated a Space-X style lift-off from a moribund long-term level of $500/ton.
Politeness demands that I eschew three-letter acronyms denoting earnest surprise.
Go figure... Pilbara iron ore producers are making record profits and stellar margins, while their customers, in steel-making, see record prices for steel and robust profit margins.
What on earth is going on?
Where did Mr Marginal, the erstwhile setter of fair and rational prices, abscond to?
Why does he not answer my calls?
When will we get a stable price for iron ore, coking coal and the gateway drug to each and every construction boom, copious quantities of cheap and high-quality steel reinforcing bar?
Evidently, it will not come from the green eye-shade deliberations of Mr Marginal.
This is a different type of market, one where the supply side and the demand side are both in the grip of highly concentrated hands. Doubtless, you have heard of the selling price-setting powers of the monopoly or the equally fearsome oligopoly. The market power of concentrated interests does wax and wane, but the Pilbara iron ore industry is only one unplanned maintenance outage away from bringing a falling market into balance.
We have seen this power manifest on the way up for iron ore when Fortescue kept its new supply in check to less than 2% growth through a period of record price rises.
What of the other side of the market, the demand side?
The Chinese steelmaking industry was the first back on track in the second quarter of 2020, when Wuhan came out of lockdown and normal service in the construction industry resumed. Through this period, when Western demand for steel took a steep dive, China grew into the gap and profited from lower input prices for iron ore and coking coal. That situation changed very rapidly in the fourth quarter of 2020 when Western steel demand was resurgent while manufacturers restocked and COVID-19 stimulus programs set fire to housing markets.
Evidently demand shot up, and iron ore prices too.
Now China is exercising state power, as only the Chinese Communist Party can, to put a lid on prices for imported iron ore. Who knows where this stops, but it leads to a simple question.
Is Mr Marginal gone for good?
I don't think so, and it should be clear from the foregoing discussion why.
In the story so far, we have a dominant supplier in Australia, with a wounded swing supplier in Brazil, that continues to suffer from outages, locked in mortal price combat with what the dedicated student of political economy would call a monopsony buyer. That word is the demand partner to monopoly, describing a sole or dominant buyer.
In such a contest, before the edifying content of the marginal revolution, there would be nothing but price chaos in the never-ending clash of supply and demand titans.
None of that makes any sense to the rest of us. Price stability is a public good. It benefits us all to know that prices will not take a flight to the Moon, on a whim, or do the Jules Verne and bore a clean shaft to the Centre of the Earth. Such things make for great cinema, but poor quality of life.
Mr Marginal is still there but we have to dig some to find him.
Since political economy looms large in this Australia-vs-China contest, we need to look for the presence of Mr Marginal on both sides of the supply and demand equation.
On the supply side, there is no Mr Marginal in Australia that any of those who wield selling price influence care about. I might like Grange Resources (ASX: GRR), but I doubt that the majors would shed a tear if the firm died. In the case of Champion Iron (ASX: CIA), listed in Australia, and mining iron ore in Canada, they may well cheer.
Miners are an unsentimental bunch. Lose a competitor and there will be another hopeful along with a big dream and a new project. I never met a geologist who was not an optimist.
The politically important Mr Marginal, for supply reasons, is found in China. There the state has continued to support domestic production of mostly low-grade ore bodies that require extensive beneficiation to bring the concentrate up to a grade that is useful in steel mills.
The specific numbers do not matter overly much, as there is two-way battle axe traffic in this present-day Clash of the Titans, but most analysts, of the long lunch era, would say: $100.
It is a round number, a good number, and one to hang your hat on. There is no point wasting valuable nosh time arguing the fine detail of a number whose average is around $100.
China probably needs iron ore prices at or above $100 USD/tonne to make the great bulk of their marginal grade industry sustainable. Otherwise, they are simply paying away in a massive subsidy to keep the industry alive, with little hope of tempering Australian dominance.
Sure, prices can fall below that and often do, but through that period the Pilbara still makes a good margin at anything above US$50 a tonne.
Now look for another Mr Marginal on the demand side.
For now, it is clearly the Chinese steelmaking industry due to state-mandated production quotas and cutbacks. However, that cannot continue indefinitely, unless China is now to retreat from their dominant position at around 60% of global steel production. Marginal cost pricing theory says this is unlikely since for many years China was accused of dumping steel below cost in international markets, as a means of building global market share.
Should they retreat from that behaviour, and we think they are as a way of limiting exposure to potential green tariffs on steel exports to Europe and the United States, then Mr Marginal will resurface in the cost of steel production outside of China. To the extent that this rises outside of China, due to green initiatives, the Chinese steel-maker margins are likely to fatten.
The tension of marginal cost pricing is restored.
On the sell-side of iron ore, it is keeping Chinese state-sponsored miners alive. On the buy-side of iron ore, it is high enough steelmaker margins to keep demand humming.
Structurally, it is our view that both the demand and supply sides of the marginal cost pricing equation have stepped higher. China would like to reduce dependence on Australian iron ore, which means tolerating a fairly high floor price in iron ore to keep its marginal miners alive. Western manufacturers face pressure on onshore supply chains, while Western steelmakers face higher imposts to decarbonize their product chains.
Markets have been the plaything of monetary theorists for many a year, but there are physical factors in the supply chain of which we speak. Grade matters a great deal for the profitability of iron ore miners. Australia, Brazil and Guinea have great reserves of high-grade iron ore.
On the other side, China rules what will soon be the largest product market on Earth. Competition with scale players like China means accepting the marginal cost equation. European and US businesses who want to source steel from outside China, and meet green targets, are going to need to charge higher prices for that. In that sense, both sides of the pricing equation have support, but it is the political interests of the players that finger the identity of Mr Marginal.
It is our contention that this market, for seaborne iron ore, will carve out a new range, where that range is rarely below the price dictated by the need to keep Mr Marginal alive.
One needs to understand that the difference in this analysis is that we do not believe the iron ore market to be one of perfect competition. It is a contest between two rentiers.
There is China, the rentier standing astride the largest market for commodities, who will level a tax and a charge, where feasible, for anyone to gain access to that market growth potential.
There is Australia, via the Pilbara, who would now seem to be extracting a rent that follows the high grade, ease of shipping, and necessity of high capital investment, to export iron ore.
Where this goes over the next decade will depend essentially on Mr Marginal. Should China decide it no longer needs a domestic iron ore supply, it will need to invest very heavily in alternate sources of supply. Should the West eschew Chinese supply chains then it will have to pay a higher price for steel, to be produced in Western steel mills, with likely more stringent environmental constraints, elevated Environmental and Social Governance (ESG) risks, and a likely higher cost of capital that depends on the kindness of reluctant fund managers.
When we survey this situation, consider the 10-year outlook for steel demand to fulfil the coming infrastructure needs of a rebuilt energy supply chain, it is hard not to like iron ore.
This price of iron ore will be volatile, but at US$100 a tonne the Pilbara still mints it.
We own Fortescue Metals Limited (ASX: FMG), BHP Group (ASX: BHP) and Mineral Resources (ASX: MIN).
We owned them before the recent price correction, and we still own them now.
The only difference is that, come dividend pay date, we will reinvest that to buy more of these names at the current lower prices. That is the long game for the long cycle in iron ore.
Look out for Mr Marginal in markets. These days you will find him wherever a politician has found a new axe to grind on behalf of their local constituency. The result is higher prices, for the principle at work is the political economy of imperfect competition. Absent these forces iron ore could easily trade at $20 USD/tonne. We don't think it will.
Salut Mr Marginal! Now to lunch.
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Dr Kingsley Jones is Founding Partner/CIO for Jevons Global. He has been Portfolio Manager for the Macquarie Global Thematic Fund and Global Head of Quantitative Trading Research at AllianceBernstein, and holds a PhD in Theoretical Physics....