Is The Iron Ore Sector A Buy?
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The iron ore sector is suddenly back in the news, with the spot price in China rising a record 18% in a single day earlier in the week. Added to the moves in January and February, this totals a dramatic 51% increase for the 2016 calendar.
The timing could not have been better for the hundreds of delegates who gathered in Perth for the 19th Global Steel and Iron Ore Conference.
The team at Katana Asset Management were amongst the attendees, and were asked to present a paper on the merits of investing in the iron ore sector.
At Katana, every investment idea is assessed on 10 Essential Criteria that go to the heart of our investment philosophy. Whilst we commonly include other stock or sector specific criteria in addition, no investment is signed off on unless it addresses each of these 10 core items.
In undertaking the preparation for this presentation, we overlayed this template to the iron sector and resources more generally. A high level summary of this analysis is below.
Of the 10 areas of analysis, 3 are of particular importance in this case.
On the positive side, iron ore and resources generally have a sustainable competitive advantage. Whilst this may not be apparent at first, the iron sector in particular has sustainable barriers to entry. The first and most significant of these is geology: it is simply not possible to create a new ore body! Either a deposit is ‘blessed’ with high grade, low strip ratios, low impurities etc or it is not. This is something which cannot be ‘manufactured’ or copied by competitors. This very trait has ensured that BHP and RIO have run a duopoly on iron ore production in this country until relatively recently.
The sector also throws up barriers to entry in terms of access to infrastructure, specifically in the form of port and rail. During the last boom, port allocations were worth their weight in gold, and prevented a significant number of small to mid-size projects from seeing the light of day.
Finally there are substantial economies of scale required to mine, transport and export in the most economic manner. Virtually anyone can dig up a tonne of ore and drop it on a panamax vessel. However, to do this on a scale that enables the production costs to be in the lowest quartile requires tens of billions of dollars.
In the investment realm, a true sustainable competitive advantage is a rare commodity. The iron ore sector has this in spades, and hence it begs the question as to why it is not a significantly more attractive sector?
As with most economics, the answer lies with supply and demand. Lets start with the demand side.
In our view, the iron ore sector is facing a structural headwind. Whilst it may be ok in the short term as China has one last stimulus hoorah, over the medium term Chinese steel production simply cannot persist at the current levels. The per capita per annum steel usage in China is off the scales, and is representative of a massive and rapid infrastructure build. Demand simply cannot be maintained at these levels.
And even more worrisome for the iron ore sector, is the word that no one is talking about: recycling!
Currently due to its outstanding properties, steel is the most recycled commodity on the planet. In fact steel recycling is greater than that of aluminium, paper, glass and plastic combined. And herein lies the issue. In 2013, 81% of all steel produced in the United States of America came from recycled/scrap material. 81%. In 2015 in China, a miniscule 8% of all steel produced was from recycled material. This is forecast to grow to 20% by 2020 and 40% by 2030.
But that’s tomorrows problem. The ‘scary’ thing is that the price has collapsed despite the fact that demand has remained robust to date. And the price has collapsed due to the other part of the equation: supply.
In effect, the 4 major iron ore miners have pursued a strategy of ‘volume at any price’. There is a flawed premise that mining houses must defend market share, even if the net financial outcome is (significantly) worse than lower volume at a higher price. In our view this is nonsensical. And it can only stem from a lack of appreciation of the power that they control.
Today, the 4 majors control between 70 and 75% of the global seaborne iron ore trade. 4 companies control up to 75% of all trade. This is an extraordinary and unique position. Even in the case of OPEC, the top 4 countries – not companies but countries- control 44% of total oil production. In fact the top 10 countries only control 66% of all oil production globally.
So where does this leave us? In summary, whilst we may see a bounce in the short term, the medium to longer term outlook is structurally challenged on both the demand and supply side. But, and this is not a small but, if the major players can develop some level of understanding and production and capital discipline, then the potential is there to generate higher returns through the cycle. The recent MOU between Fortescue and Vale may be the first signs of this emerging.
Romano Sala Tenna is a Portfolio Manager at Katana Asset Management. The Katana Australian Equity Fund is a long-only, broad-cap Australian Equity fund focused on maximizing risk adjusted returns for clients. This article is general information and does not consider the circumstances of any individual. To learn more about the Katana Funds, please click here.