Bust to Boom: The rise and swift fall in iron ore prices

The recent iron ore price crash continues to play out across Australia, particularly in the rich fields of North-West WA. Between April 2020 and May 2021, the iron ore price rose relatively steadily from circa $US80/t to a peak of US$233/t, fuelling record profits and dividends from the ‘Big 3’ producers, BHP, Rio Tinto and FMG. However, driven by a slowdown in demand from China where 80% of Australian Iron Ore is exported, the iron ore price plummeted to a low of US$94/t in September 2021.

The China Effect

To support China’s commitment to peak carbon emissions by 2030 (and to prepare for the winter Olympics), the Chinese government has sought to restrict 2021 steel output to 2020 levels. Given steel production in the first half of 2021 exceeded the prior corresponding period by 11%, pressure for cutbacks in the second half of the year is mounting. In addition, the potential oversupply of residential property, well-publicised in the recent Evergrande affair, may support a material reduction in steel production over the short to medium term.

As China accounts for 75% of global iron ore imports (the next largest importer, Japan, accounts for just 6%), it appears unlikely that capacity will be taken up by other countries in the global supply chain.

Stakeholder Impact and Mitigation Strategies

The effects on Australian stakeholders are far-reaching, and we summarise below some expected consequences and proactive measures for the supply chain:

Big 3 Producers – The large Australian miners have become experts in cost management, and currently produce at between US$13/t and US$18/t, resulting in significant free cash flows even at supressed prices. Notwithstanding, the effects of COVID-19 on supply chains and labour movements have resulted in increased costs and project delays (for example FMG’s US$1 billion cost blowout at Iron Bridge). In the context of a rapidly changing environment, an even more ruthless scrutiny of costs is required in the short term, supported by robust purchasing and cyber controls with employees making ‘big ticket’ decisions whilst working from home.

Junior Miners – While the lure of increased prices and readily available capital has resulted in a number of marginal miners ramping up to production over the previous 18 months, these miners produce at materially higher prices than the Big 3 Producers (often in excess of US$100/t). ASX-listed junior miners have already halted production until prices stabilise whilst operations are reviewed. Junior miners should ensure forecasts are up to date and robust and they should conduct scenario analysis to allow for quick decision making (for example temporary shut down or care and maintenance at various prices).

Contractors – A number of large contractors have flagged additional costs associated with COVID-19 labour shortages as a headwind for FY22 earnings and reduced production coupled with an increased focus on cost-management from producers as prices remain low may further dampen earnings. Contractors should make a plan and actively engage with producers to understand their current status. Management of working capital and outstanding debtors is particularly crucial during a period where receipts from iron ore sales may cease.

Lenders – A reduction in forecast cash flow with falling prices, compounded by potential project delays and cost blowouts, increases the risk of covenant breaches and subsequent defaults from junior miners or contractors. Fortunately, larger miners have utilised recent high prices to repay debt, with FMG reporting net cash of US$2.7 billion at 30 June 2021 compared to net debt of US$3.1 billion three years’ prior. Lenders should pro-actively engage with borrowers to understand any changes to forecasts and potential covenant breaches (before they materialise). The renegotiation of any terms or covenants may be an opportunity to re-evaluate facility structures and/or seek additional security.

Government budgets – According to research from CBA, Australia’s nominal GDP is forecast to reduce by $6.5 billion for every US$10 fall in iron ore prices, relative to the federal budget assumptions. Other research estimates that the same movement in the iron ore price impacts the WA budget by circa AU$0.8 billion. Governments have adopted conservative forecast prices of US$55/t during FY22, but care should be taken to ensure high prices are not ‘baked in’, including in relation to, for example, payroll tax revenues, wages and consumer spending (i.e. GST revenue).