The gradual recovery in global economies coupled with curtailed supply are likely to be supportive of Australia’s iron ore prices in the coming months, writes Luke Smith, Portfolio Manager for Ausbil Investment Management.
Iron ore has been one of the bright spots in the commodities space and has been Ausbil’s preferred commodity over the course of 2020.
Looking forward there are a number of factors that indicate continued strength for the commodity. Increasing economic activity in China and across the globe is supporting iron ore demand, while on the supply side global supply disruptions represent further upside risk, and the potential for prices to move higher.
Chinese demand is strong… and accelerating
Demand for iron ore has been resilient through the COVID-19 pandemic, as a result of the dominance (and strength) of Chinese demand, which represents roughly 70% of global iron ore demand. Chinese economic activity was impacted heavily in the first quarter and has now recovered ahead of the rest of the world.
Economic activity is now accelerating, with stimulus targeted towards steel-intensive industries. Within China, approximately 60% of steel demand is used in the construction sector. Construction activity, particularly focused on infrastructure, is an area that is clearly being supported by the Chinese government to rapidly underpin and accelerate economic growth.
This was confirmed at the recent National People’s Congress (NPC) meeting. Despite backing away from their headline GDP target, the NPC announced an increased level of ‘special purpose’ bonds focused on infrastructure, confirming that investment targeted towards steel-intensive industries is going to continue to accelerate over the course of the year.
Chinese steel production has grown 1.9% year-to-date, compared to 2019, given this strength in infrastructure investment, along with the recovery in other core areas such as real estate investment, machinery and auto sales.
We expect Chinese steel (and therefore iron ore) demand to remain buoyant over the remainder of the year.
Chinese GDP should accelerate materially in the second half, and the targeted nature of stimulus towards infrastructure in particular should be supportive for steel demand.
Demand recovering in the rest of the world
Outside of China, steel production and demand have been weak, with manufacturing and construction activity severely impacted by COVID-19.
However, we have started to see activity progressively recover on a global basis, which provides further support for iron ore demand.
Supply curtailed during COVID-19
Another key feature of the market earlier this year was the lack of ferrous scrap availability.
COVID-19 impacted both scrap generation and collections, particularly in China but also across the globe. As iron ore is a direct competitor to ferrous scrap, this has helped to support demand.
Iron ore production has also been curtailed due to COVID-19 restrictions in a number of smaller (but not insignificant) exporting countries, such as South Africa, Iran, Peru and Canada.
At one point earlier in the year, this resulted in roughly 100mtpa of iron ore supply being temporarily removed from the market.
Exports of iron ore from the number two global producer, Brazil, have also been challenged over the course of the year. Exports from Brazil are down 12% year-to-date, compared to 2019. Brazilian mining giant Vale have already downgraded volume guidance given weather and operational challenges.
Vale was recently ordered to shut its Itabira mining complex by the Brazilian labour authorities, apparently given concerns regarding the incidence of coronavirus within the workforce. The mining complex represents roughly 33mtpa (~11%), and while supply may return at any point as Vale look to rectify concerns, it highlights the heightened risk of supply disruptions from COVID-19 to the world’s second largest iron ore exporting nation.
We continue to see risks of disruption from Brazilian production in the short to medium term given the spread of COVID-19 within the country, and struggle to see Vale achieving guidance given the increase in production that is needed in the second half.
Iron ore squeeze supportive of price
The impact of these factors on both demand and supply is that the iron ore market will be in deficit over the course of the year, reflected by the recent strength in prices.
The significant reduction in Chinese iron ore port stocks over the course of the year confirms this tightness, and highlights how the commodity is at a tipping point, dependent on whether we see further supply outages as demand accelerates in China and the rest of the world.
Australian production has remained strong through this period of turmoil. The Australian diversified miners, in Rio Tinto and BHP, combined with pure-play iron ore miners like Fortescue Metals, will greatly benefit from the strength in prices.
From an investment perspective, we believe this price strength is likely to translate into earnings upgrades for both the Australian diversified and pure-play iron ore mining companies, with the sell-side equity and commodity analysts continuing to underestimate the strength of the market.
With the majority of current earnings generated from Iron Ore, the resultant strength in free cash flow is also likely to further support capital returns to shareholders.
