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Iron Ore and Petrochemicals Share The Same Delusions

China, Company Strategy, Polyolefins
By John Richardson on 10-Sep-2014


By John Richardson

BACK in January we wrote:  “As China’s investment growth model is unwound – for economic as well as social reasons –  iron ore prices [will] decline significantly, leading to the failure of the smaller mining companies and some of the service providers. This could happen just as a lot more iron-ore supply hits the market.”

Following a retreat in pricing of some 40% over the last two-and-a-half weeks to $83.20/tonne, one of Australia’s junior miners, Western Desert Resources, has called in administrators and receivers. The last time that iron ore prices were this low was in October 2009.

The trouble, though, is that the iron ore market still doesn’t get it.

Widespread assumptions are that:

  • This is  just a temporary phenomenon, driven by a pause in Chinese buying. Buying will soon roar back, especially if prices stay low or decline even more, as China’s steel mills will seize the opportunity to stock-up on cheap raw materials. Perhaps, but this will not be a sustainable recovery.
  • It is a game of survival of the fittest. Rio Tinto, BHP Billiton and Fortescue Metals will remain in excellent financial health because a few  of the smaller Australian miners will stop production, whilst China will close higher-cost mines. The big miners have total production costs well below the current iron ore price.

As we pointed out in January, and have been pointing out for several years now, the changes in China’s economy are of a structural and long term nature. It defies logic to expect demand growth in steel to return to anywhere close to its 2009-2013 rates of increase.

And we also argue that it is wrong to assume that we are in a game of survival of the fittest.

What if a few of Australia’s junior miners have their debt written off and are acquired by private equity companies, which then run mines hard in order to just cover variable costs?

As for China’s mines closing down, good luck with that idea, argues Shanghai-based CLSA commodity strategist Ian Roper.

“Don’t underestimate China’s desire for more self-reliance. They have invested a lot of money in projects like Gindalbie Metals and Citic Pacific because they really don’t like relying on the oligopoly for supply,” he told The Australian newspaper.

“They are going to continue to invest in their projects even if they are economically questionable.”

The same, too, applies to petrochemicals – in particular right now polypropylene (PP).

One has to, of course, be careful of anecdotal reports. Nevertheless, the anecdotal evidence from our China team suggests that as much as 4.1m tonnes/year of new capacity is due for start-up in China in 2014.

This would be into a China market where real PP consumption in 2013 was 17.9m tonnes with imports at 5m tonnes, according to ICIS Consulting (real consumption is consumption adjusted for inventories).

On  a pro-rata basis, capacity additions are likely to be a great deal less than 4.1m tonnes/year. This is, of course, because plants will  have started up at different points during the year.

Seeing is also believing in China. How many of these projects, especially in the more remote regions of China, are real?

And where the projects are real, will they be able to overcome logistics and manpower issues in order to run at high operating rates?

Many of these new plants are in western China, a long distance from the major PP consumption markets. Plus, we are continuing to hear of tight supply in blue-collar labour markets that could make it hard to find enough engineers to run these plants.

But we have already seen a substantial build-up of real and operating capacity in purified terephthalic acid and polyvinyl chloride to the point where China has become a substantial exporter of both of these products. In the longer term, might the same happen with PP?

And do not assume,  as some people do, that China will only be interested in exporting standard homopolymer grades. Moving to a strong position in higher-value copolymer grades could well fit with China’s attempt to escape the “middle income trap”.

Our central point with both iron and ore and petrochemicals in China is that social and political factors come into play here.

There never has been a level economic playing field for any foreign company involved with China. Why do you think this will change?