Rust II

The Cost Curve

These things kind of speak for themselves. You can see the market apex (RIO, BHP and Vale) is perfectly positioned, and (theoretically) production would have to almost halve to put them in danger of an operational loss. The high cost Chinese production in red was what was supposed to drop out to keep the price above $120 – whoops.

How the Players are going to Play it

 

This appears to be one of those common examples where the participants in a market seem to be conspiring amongst themselves to completely and unnecessarily wipe out the entire profits of their industry.

As the lowest cost producers, BHP and RIo will assume they can afford to keep mining, and have indicated they will do so (to put it mildly). While they will shelve some projects in the pipeline, and have already started, they will make up for lower prices by pumping out greater volumes as they continue to expand production.

The self heralded New Force (Fortescue) has no choice but to produce. Their debt is 10x EBITDA and must be repaid. They certainly have no flexibility to halt production.

The smaller players will have to act according to their capital structure. Those that have debt to pay will have to produce, and if all the profits go to their bond holders and (somewhat foolish) bank lenders and the equity is worthless, then so be it.

Who knows what China is doing, but my best guess would be that they will operate at a loss. Low iron ore prices are undoubtedly in the broader nation’s interest, and combined with the social benefits of keeping employment high the central commanders are quite likely to err on the side of excess productions

So what are we left with? A situation where the entire industry will out produce itself into oblivion. (Actually, this isn’t even close to the worst I’ve seen … for collective stupidity you can’t beat the shipping industry, but that’s a post for another day).

What they should be doing

 

Those that can stop producing should absolutely stop, but to do that they will need to have little or no debt (a rare situation). The long term benefits are huge – their competitors will be producing in a low price environment, while in 10 years time, when the worlds GDP and population growth is substantially higher, all that ore will still be sitting in the ground, ready for a decade of production at costs way below those of the rest of the industry, which by and large would have already mined and shipped off their best assets. How many people have 20 years to wait, however?

To some extent, this is going to get a lot worse when the Apex decides to make up for lower prices with higher volumes of low cost ore.

It also comes down to capital structure. Miners, which know better than anyone else the extremely well publicised increase in production, which will really only hit full stride in 2014, should have raised equity last year. Would that have left them with too much cash? They shouldn’t have cared, as they’d now be able to buy their own shares back at much lower prices, providing windfall profits for their buy-and-hold investors, or been best positioned to pounce on distressed assets. But who bothers to think like that?

A five year view

 

Personally I think this will be a slow motion train wreck. We’re in the ‘plunge’ part of the cycle. Invariably to some extent the cost curve will work as it should and the higher cost guys should reduce their exposure somewhat. Those who have disconnected the long term thesis (iron ore prices going down over the next five years) with their trading limits, and who bet against the industry only recently will probably have to buy back their shorts at a loss in the short to mid-term. Noones going bankrupt tomorrow. The combination of these two factors will certainly lead to some kind of rally.

But in 2014 the reality of the increased production profiles will hit, and those that left themselves exposed to the spot price with weak capital structures will be at the mercy of their various bank but (mostly non-bank) lenders, and the industry will be up the creek, so to speak.

Where could the upside come from?

 

In a nutshell, there needs to be a demand surprise. Africa gets its act together and plays the role of China in the noughts, in the teens (these decade names suck). Or perhaps even low price itself is enough to boost steel demand. It’s quite hard to see that happening however, as their is just so much spare capacity in the industry (by one estimate, China’s steel capacity is 850m tonnes a year, but last year only used 630.

Furthermore, if the price goes up, the miners will just put those shelved expansion plans back on the table, and push down the price and wipe out the value of their equity once again (hence five year view). The size of the demand shock would have to be enormous.

And remember, it wasn’t so long ago that the iron ore price was in the $20-30 range.

How to make a dime and a buck

 

What do you think?

This is how I would play it. There is no point in playing around with the equities.. I mean, you can. There is a good chance you will do quite well in the short term, as it looks like one of the most powerful forces in markets, that of the short squeeze, has just been put into action, and these things tend to be quite dramatic. But looking ahead more than six months, it is almost impossible to see where the bumper profits will go to.

Instead, I’d suggest looking in the debt markets, particularly for eg. the New Force. What you want to find are great, low cost assets, with high financial costs. (Eg $50-60 operational break-even on the cost curve, but $80-90 once financing costs are taken into account). This would be trading below par, and would provide a handy coupon while you wait.

If the predicted collapse in the industry actually occurs, you are the one holding the cards. As a debt holder (and this will completely vary case by case according to the various instruments that have been used and their particular features) you might be able to force an equity raising. So the miner would have to sell more shares and completely smack it’s already whacked share price. management would then be forced to use the proceeds to pay you back at par. And that, say around 2015/6/7, would be the perfect time to consider buying the shares, and participate in whatever upside the industry has over the next 10 years. I’m guessing the Roaring Twenties will be a great time to be holding enormous amounts of low cost mining assets.

If this plays out as expected, I will probably be doing this somewhere, so get in touch then if you want to get involved.

One final thought

 

Something that seems to be missing from the commentary is the effect that low iron ore and steel prices have on all of us. Steel (and other base metals) are one of the key inputs into the global economy, and reducing that cost is undoubtedly a great thing for most people. It might be deflationary, but it’s the good kind of deflation, like high oil prices, which just concentrate wealth in the handful of lucky misogynistic medieval desert dwellers, is the bad kind of inflation.

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2 thoughts on “Rust II”

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