The real challenge is a lack of challenge

Economic growth

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EmperorWe all remember the Hans Christian Andersen story about the Emperor with no clothes.  His subjects were told that only those who were stupid or incompetent would be unable to see his wonderful new suit.

Of course, nobody wanted to appear stupid or incompetent.  So when the Emperor paraded in his new clothes, nobody wanted to tell him the obvious.  It was left to a child to cry out, “But he isn’t wearing anything at all!”

The story has been translated into over a hundred languages.  But it seems its message has not been learnt by the iron ore industry.

It has vastly over-expanded in the mistaken belief that China would continue buying more and more iron forever and ever.  A child, of course, could have told them this was unlikely.  But these days, highly-paid CEOs travel in private jets, and never have to meet children.  So they suffer, no matter how brilliant, from a lack of challenge.

Thus the Top 5 iron ore producers – Rio Tinto, BHP Billiton,Vale, Anglo-American and Fortescue –  are continuing to expand production even though the outlook for demand growth continues to weaken in China, their main market.  As the Wall Street Journal notes:

  • China imports two-thirds of internationally traded iron ore
  • One quarter of the world’s iron ore is new production
  • Global output from the Top 5 will grow 40% by 2017 to 1.5bn tonnes

Of course, the miners’ CEOs are not stupid.  Thus the CEO of Anglo-American recognises that demand will slow:

China will not spend what it has been spending on infrastructure.There are still plenty of buildings with no one in them”

LOW-COST IS NO LONGER A GUARANTEE OF FUTURE SUCCESS
Instead, the problem is the lack of challenge.  Nobody at senior levels dares to say the obvious, that this is going to be a major disaster and needs to be stopped now.  Instead, groupthink takes over, and they convince themselves that someone else will shutdown.Iron ore Sept14

Yet a moment’s research would show that low-cost on its own is no guarantee of profitability in an over-supplied market.  Large companies rarely shutdown because of cost issues:

  • Even if they go bankrupt, there is always a new investor prepared to pay pennies on the dollar for a punt that things might get better
  • And failing that, governments will often nationalise the operation to preserve jobs and tax revenues

Plus, of course, much of the assumed demand in China has been fictional.  As the blog’s ‘Your Compass on China’ Research Note highlighted in June, more than 100 million tonnes of iron ore is currently in bonded warehouses in China, being used as collateral to finance the housing bubble.  That is 10% of the current market, on its own.

Thus it is wishful thinking by the producers to imagine that someone else will rescue them from their ill-advised investments.  As the chart shows, prices have already more than halved from their peak.

But prices are still more than five times the level of 10 years ago.  And so the logical direction is for them to continue downwards, by a long way, as it is most unlikely that Chinese developments will make them profitable.

Why should Chinese plants shutdown on economic grounds?  China’s declared policy is “socialism with Chinese characteristics”.  And it will not allow jobs to be lost if this means its government might lose power due to social unrest.

Already a Reuters analysis suggests local government and other subsidies were responsible for four-fifths of reported H1 profits in China’s steel industry.

This leads the blog to wonder whether someone needs to arrange for a classroom of children to point this out to mining company investors instead?

 

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