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Iron ore tumbles on China woes despite robust outlook
Iron ore prices have fallen to levels not seen since the onset of the pandemic as global steel demand, particularly from China, begins to waver.
The Singapore November futures contract currently trades at US$77.57, down 17 per cent this month. Just six months ago it was fetching more than US$140.
Over the same period, the three major producers – BHP, Rio Tinto and Fortescue Metals Group – have seen their share prices sink 19.9 per cent, 20.3 per cent and 28.4 per cent respectively. For comparison, the S&P/ASX 200 is down just 5.1 per cent.
The world’s second-largest economy remains handicapped by zero-COVID policies that still entail strict isolation requirements. A recent Nomura survey estimated 9.2 per cent of China’s GDP is under lockdown, compared with 7 per cent in mid-October. Then there is the deflating of a multidecade property bubble, with new land sales and projects falling.
The result is slowing economic activity. October’s purchasing managers index fell to 49.2, while the non-manufacturing gauge, which measures construction and services activity, dropped to 48.7 – both below economists’ forecasts. A reading below 50 indicates a contraction in the economy.
China is considered the primary cause of price gyrations given it accounts for 70 per cent of global seaborne iron ore volumes.
The iron ore price is also weighed down by broader global economic fears, in particular a recession in Europe and another likely one in the United States.
Commonwealth Bank believes prices should bottom out in the March quarter of next year but that this will depend on if and when China changes its COVID-19 policy.
“A shift away from China’s COVID-zero [policy] by the end of March 2023 should see iron ore prices lift in the following quarters,” the bank says in a research note.
Forest for the trees
Given the bleak macroeconomic backdrop, it would be easy to place iron ore in the too-hard basket and move on to greener pastures. However, Australian Eagle Asset Management chief investment officer Sean Sequeira says the fundamental demand and growth outlook for iron ore remains attractive.
BHP forecasts that annual steel demand will double between now and 2050, underpinned by global population growth, urbanisation, rising living standards and power decarbonisation.
Sequeira acknowledges the near-term economic issues, noting the fund reduced its position in Fortescue given the company’s outsized exposure to China relative to other majors.
“We want to know where our risk lies,” he says. “Consequently, we look at our holdings and say, which one exposes us the most?”
The fund instead added Rio Tinto, given its high-quality asset base, growing demand for its commodity stable and improving production profile. Sequeira also highlights the attractiveness of the Oyu Tolgoi copper development in Mongolia, which looks mispriced by the market when compared with the likes of OZ Minerals.
“Rio is trading on a price-to-earnings ratio of seven compared to OZ Minerals in the mid-teens,” he adds. “So you get the same exposure from Rio at a cheaper price.”
Repositioning a portfolio in this way demonstrates to investors how near-term risk can be minimised without lost exposure to the longer-term growth runway of a commodity. It also highlights how one company can provide a similar exposure to two separate ones, and vice versa.
Negative jaws
Notwithstanding the longer-term bullishness, Sequeira is cautious of inflation pressures affecting not only iron ore but commodities across the board. For example, Fortescue recently announced a 16 per cent increase in unit costs, largely due to labour constraints and higher energy costs.
Falling revenue due to lower commodity prices paired with cost increases leads to what’s termed ‘negative jaws’. Profit compresses rapidly, and companies on the higher end of the cost curve can be caught out.
“Later in the cycle, it’s always more prominent,” Sequeira says. “It always becomes a real problem.” To protect against the downside, investors must satisfy two requirements: “have you got a world-class asset base that someone will want to take at some point? And do you have a balance sheet that’s not going to get you in trouble?”
