Pump up the volume

April 7, 2011, 3:03 pm By Andrew Page andrewpage

The trouble is that many of us have misinterpreted the facts and are convinced of a period of exceptional returns.

For some time now the dominant theme behind Australian economic prosperity has been the resources boom, driven by China and other emerging markets. It has, either directly or indirectly, helped us weather the worst of the GFC, keeping unemployment low and incomes high. Of course it has also led to spectacular profit within the mining sector.

But then again, you'd have been living under a rock to not know this; it's all we ever hear about in the financial press. The trouble is that many of us have misinterpreted the facts and are convinced of an enduring period of exceptional investment returns. I would urge caution in this regard.

Iron Ore

The most dominant resource underpinning the boom has been iron ore. It is the main ingredient in steel, and indeed almost all mined ore is used in its production (over 98%). The vast construction we have seen in places such as China is what's driving demand and, given that this phenomenon is likely to continue for a good while yet, there is little risk that global demand will abate any time soon. In fact the Reserve Bank has declared that the current boom could last another decade or more.

Today the global demand for iron ore exceeds two billion metric tonnes, having more than doubled over the past decade. Because it takes some time to establish new mines (and the related rail and port infrastructure), supply has lagged the growth in demand. Of course when demand exceeds supply the inevitable consequence is for the price to rise. And rise it has: iron ore has seen a near six-fold increase in price over the past decade.

So miners have benefited in two ways; firstly in terms of the amount of ore they are selling and secondly in the margins they are enjoying. Happy days!

There's good news and bad news

While the growth in demand has been phenomenal, most expect it to level off in the coming years. That isn't bad news because demand growth will be plateauing at historically very high levels, and is the reason why so many are enthusiastic about the prospects for our iron ore industry.

Nevertheless, although it is easy to forget at times, we must understand that what is good for the industry as a whole isn't necessarily good for investors. Moreover, we must appreciate that it will be an ongoing mining boom in terms of volume. It's a different story for price.

The fact that demand has surged ahead of supply is not a reflection on the efficiency or competency of the industry; it simply takes time (and LOTS of capital) to establish mines and the related rail and port infrastructure. But it's a mistake to think that the industry has been idle.

In Australia alone, the industry has a stated goal of increasing production to one billion tonnes annually by 2020 (a near doubling from current levels). Even in the near term, major players such as BHP Billiton and RIO Tinto are aggressively expanding output from their assets in the Pilbara region, with expectations of output increasing close to 30% over the next couple of years. Meanwhile Fortesque Metals is expecting to triple its production by 2014.

Of course, as blessed as we are in terms of our minerals resources, we by no means hold a monopoly on iron ore (the metal is actually mined in over 50 countries). Africa in particular is worth considering; it has substantial deposits and with the help of Chinese investment in related infrastructure we will see a massive ramp up in production in the coming years. In fact there are currently over 40 major projects underway in Africa, many of which will start producing (or see a significant increase in production) in the next few years.

The bottom line is that there is a lot of iron ore out there and a lot more will be hitting the market in coming years. The Brazilian mining giant Vale, the largest producer of iron ore, stated recently that it expected global iron ore production to increase by 50% before 2015.

Economics 101

So with supply expected to soon catch up with demand, most experts forecast that the price of iron ore will return to much lower levels. An influential United Nations study expects a surge in iron ore supply as soon as 2012, with prices likely to drop back to 2008 levels, while the Australian Bureau of Agricultural and Resource Economics and Sciences (ABARE) expects Iron ore will average $93/tonne by 2016. That's close to half the current price.

So there is little doubt that producer margins will inevitably come down as a result. This isn't the end of the world for companies like BHP Billiton. Due in part to the quality of their deposits and the economies of scale they enjoy, BHP can extract ore at about $40/tonne; so any sale price above this essentially represents profit. So while their margins will be reduced, their iron ore operations will nevertheless remain quite viable so long as the going rate for iron stays above this level.

For other players the cost of extraction is much greater. There is a wide range of production costs out there but the point is that those who cannot produce and ship their product at a cost less than the market price will become uneconomical.

What does this mean for investors?

Although prices and margins will certainly reduce, the industry as a whole will largely continue to be an important source of income for Australia. Lots of people will continue to find employment within the industry and will spend their money in the wider economy. The boom will continue, but investment returns will quite likely return to more typical levels.

From an investment perspective, what matters is growth in company earnings and ongoing positive sentiment towards the sector. And in this regard there is reason for caution. As far as the big players are concerned, there may well continue to be ongoing growth in earnings, but that RATE of growth will be far less than what we have seen in recent times. Earnings growth will come from the growth in the volume of ore that is shipped, not in the growth of prices. Indeed, a certain level of volume growth is necessary to simply compensate for the drop in margins.

For the smaller players, only those that have lower fixed costs and can ship significant volumes are likely to remain attractive. Needless to say, those hopefuls that are expecting to reach production stage in the next few years will be arriving on the scene at a time when iron ore prices will be much lower and supply will be much higher. Investors that base their expectations on the current situation will be in for a rude shock.

The other thing to note is that shares are valued according to future expectation. So a revaluation of the industry is likely to occur well before prices actually start to drop; all that is needed is a change in sentiment. The timing, as always, is difficult. But when the revaluation comes it will most likely be significant and swift, as downward revaluations usually are.

The bottom line

The iron ore game is traditionally one of high volumes and low margins. Given the supply/demand dynamic we are likely to see in the coming years, those miners that have high fixed costs and cannot adequately compensate for reduced margins with increased volume are on very shakey ground indeed.

While the bigger players will continue to extract decent returns, they will probably fail to match the current degree of profitability. In other words, the industry will return to its usual state, with supply and demand in closer balance, and with investors receiving rather ordinary returns. That at least is the lesson from history.

If you want to learn more about rational, value investing, visit www.teaminvest.com.au

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