Why Iron Ore Prices Are Set To Fall to US$40

Loading of iron ore

Goldman Sachs isn’t bullish on iron ore. The bank has maintained a negative outlook for the long-term future of prices for some time. And it’s not shifting its position on the troubled commodity.

If you’re one of the big Aussie iron ore producers, now is the time to start worrying.

The influential bank predicts iron ore prices could fall a further 30% by 2017. It predicts an expanding market supply, in addition to declining Chinese steel production. In other words, prices are heading in one direction only — down.

Of particular interest is Goldman’s take on steel production. Once Chinese steel production ‘peaks’, the bank says a sharp contraction will follow suit.

That goes against market sentiment which says that, at worst, steel production will merely level off. What this tells us about future prices is damning.

In the event of a major contraction, prices could tumble in no time. And it’d put an abrupt end to iron ore’s rebound since July.

But even this slight price recovery isn’t cause for much celebration.

Iron ore prices have fluctuated between US$40–60 since the start of the year. Despite the rebound over the last five weeks, prices are still down 20% on last year. If Chinese steel production starts contracting, demand for iron ore would collapse. And prices would fall in tow.

The market can’t rely on the recovery continuing for much longer, that much is clear.

The recent gain is largely down to two factors. One is lower-than-expected export volumes from Australia and Brazil.

The other is that the price of steel in China rose over the last month. That suggests that peak production isn’t a reality just yet. But it is on its way.

The effect of the yuan devaluation on the iron ore market

The iron ore gains continued last week despite China’s currency devaluation. The yuan debasement was a cause for concern among Aussie exporters. It raised the prospect of soaring import costs for China. Higher import costs are harmful as they weigh on export volumes from Australian producers. You’re left with fewer buyers, higher prices, and even more supply than you wanted.

Goldman Sachs isn’t sure about the effects of the devaluations however. The bank believes it’ll have little effect on the broader iron ore market. In a recent note, the bank wrote:

The yuan devaluation and the recent supply disruptions are what we consider a sideshow for the iron ore market. Supply growth will resume in the short term’.

There’s truth to what Goldman is saying. Once supply increases, as is expected, prices should dip again. And the devaluations haven’t affected prices as much as anticipated. In fact, iron ore hit a 2-month high last Thursday following the explosion at the port of Tianjin.

But that’s an extraordinary circumstance. There’s also good reason to believe the end of the rally is approaching fast.

China typically experiences a lull in steel production during the third quarter. That’s down to the effects of seasonal cycles. At the same time, producers continue to expand global supply, suppressing prices further. It’s expected iron ore exports will continue flooding the market with supply well into next year.

In light of that, where does Goldman see iron ore prices heading into the future?

It sticks by its earlier estimate that the commodity will fetch US$49 during the third quarter. It then predicts a price drop to US$48 a ton in the fourth quarter. By mid-2016, the bank’s estimates put iron ore prices at US$46 a ton.

That’s not a great outlook for the market. And it’s more troubling for the likes of BHP Billtion [ASX:BHP], Rio Tinto [ASX:RIO], and Fortescue [ASX:FMG]. 

As Goldman analysts put it, the summer (Australian winter) of 2015 is the calm before the storm.

Mat Spasic,

Contributor, The Daily Reckoning

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