Here’s a Thursday tip for you. Don’t go bottom fishing for iron ore stocks.
Sure, they’re due for a rally at some point, maybe even now, but it’s a rally to sell.
Since the start of the year, the iron ore price has gone from around US$130/tonne to around $70/tonne, as of yesterday. That’s a worse performance than even I, a constantly droning China bear, expected.
I thought US$85/tonne might be a decent year-end target. It wasn’t; the price went through that level like a hot knife through butter. We might end the year in the US$60s. What happens when a flood of new supply comes onto the market next year is anyone’s guess.
That means all the marginal producers, like Mt Gibson Iron, Atlas Mining, BC Iron and even Fortescue, probably won’t survive. Not in their current form anyway. You’ll see capital raisings (assuming anyone wants to stump up more cash) asset sales, mergers…and any other survival strategy you can think of.
And then you’ll see the administrators called in.
That will all probably take another 12–18 months to play out. In the very short term though, you could see a bounce in the sector and renewed hope that ‘this is the bottom’.
I say that because today’s Financial Review has a story about the dwindling fortunes of the iron ore magnates.
‘The plunging iron ore price is wreaking havoc on Andrew Forrest’s personal fortune, which has more than halved to just $2.8 billion and puts him outside of the top 10 richest people in Australia for the first time since 2006.’
Whenever the mainstream media think it’s time to do a piece on the falling net worth of someone, that person (or sector) is probably due for a reprieve. So expect a little bounce soon.
But even for Fortescue, the third largest producer in Australia, the situation doesn’t look healthy longer term. Still, boss Andrew Forrest remains stoic, to put it kindly.
‘Mr Forrest, who is Fortescue Metals Group founder and chairman, was confident the Pilbara miner could withstand the weakening iron ore price and would continue providing capital for his philanthropic work.
‘“I can assure you that Fortescue dividends will continue to support philanthropic endeavours across Australia and around the world.”’
I’m tipping that Fortescue will cut its divvy at the half year result, due early next year. At current prices, I reckon it’s barely making enough to pay its creditors, let alone the equity holders.
Remember, Fortescue doesn’t receive the benchmark price for their iron ore. They have a lower quality product, and so it sells at a discount. When you need to sell a lot of it, and traders and steel mills know it, sometimes that discount can get pretty big.
At current levels, Fortescue is probably selling in the low US$50s. At these prices, I estimate they are making a loss when you take depreciation into account. At the cashflow level, they are barely breaking even.
Anyway, we’ll know soon enough if Forrest’s stoicism pays off. He’s certainly been in this position before.
A couple of years ago, I spoke after him at a conference in WA. (The room thinned out quite a bit after he finished, as I remember). It was around the time when the iron ore price was last under pressure in 2012, and the company was drastically trying to cut costs.
He was characteristically sanguine when asked about the iron ore price, and said that China and stimulus would push the price back up.
I commented afterwards that I thought he was being very optimistic. My view was that the iron ore price would fall and settle at much lower levels. I was wrong; he was right. China panicked and reignited their credit boom, sending iron ore prices back into boom territory.
But that wasn’t a good thing. It reaffirmed all the wrong beliefs of the iron ore miners: that China would underpin the price in the long term, that China’s steel industry would continue growing strongly until 2030, that millions of additional tonnes were needed to meet the growing demand.
That’s what credit booms and easy money do. They distort price signals, which then lead to bad investment decisions. Right now, iron ore is suffering because of it. The false promise of endless demand is now dawning on them just as billions of dollars of investment comes to fruition as new supply.
So it turns out I was wrong first, and then right. That’s always going to happen in investment markets. You’ll always be wrong at times. Don’t worry about that. The thing to try and control is how you react when you’re wrong.
That is, try not to lose too much money by being wrong. In this case, my opportunity cost was not being in the iron ore miners post their 2012 low and subsequent rally. I can live with that.
Now that the idea has worked in my favour, I’m short iron ore miners — Fortescue in particular, which was a standout short at the start of the year. The key is to find the false promise in the markets and bet against it.
As I said earlier, the pain will continue for the iron ore miners for much longer. China’s boom isn’t coming back. The best that they can do is to manage the bust and promote growth in other parts of its economy. Those ‘other parts of the economy’ are not friendly to Australia’s China centric growth model.
We’ve rolled the dice on China, and China is winning. We’ve invested in excess commodity capacity while they are buying up our productive land and food-producing assets.
Good luck to them. If we’re dumb enough to give our best assets away (and what better assets are there than the ones that offer a strategic supply of food?), no wonder they’re loading up. Who wouldn’t?
That’s the problem when your economic model is based around the wealth effect of low interest rates and rising property prices. The lack of savings and encouragement of debt accumulation means we have to bring in foreign capital to support our asset prices (our ‘wealth’).
To do that, we need to support ‘open’ capital markets and basically approve any sale that brings the cash in.
When you’re in debt and are running a Ponzi economy, your options tend to dwindle. Australia is running out of options.
For The Daily Reckoning Australia