Turmoil in iron ore markets

Since the beginning of 2019, global iron ore markets have been rattled by oneafter-another supply-side issues. As a result, the key steel-making input is inching close to five-year highs. While US-China trade negotiations remain a contentious issue, there could be selective investment opportunities on offer, especially in a scenario of uncertainty-induced sell-offs.

The year 2019 has been full of (calamitous) events for the global iron ore markets. It all started with a fatal tailings dam accident at Córrego do Feijão mine – owned by Vale, the world’s largest iron ore producer – in late-January 2019. In the aftermath of the disaster, Vale announced it would decommission c.10% of its annual output (2% of global production) over the next three years. However, a few days later, on a precautionary note, a Brazilian court ordered Vale to halt operations immediately at its Brucutu mine (30mtpa capacity). Even Rio Tinto and BHP Group reported varying production limitations due to unfavourable weather conditions and/or operational disruptions in Australia. This was when fears of major supply-side limitations started unnerving the markets.

The markets were somewhat calmed in April 2019, when a lower Brazilian court suddenly granted Vale the permission to resume operations at Brucutu. However, panic resurfaced in May 2019, when:
1/ a higher Brazilian court reinstated the production ban at Brucutu, thereby reversing the lower court’s previous month’s decision; and
2/ the US imposed new sanctions on Iran, this time targeting the country’s metal exports; in 2018, Iran exported c.14mt of iron ore.

As a consequence, the iron ore price has galloped >30% to c.$95/t – very close to a five-year high of c.$100/t. Remember, collectively, Vale’s suspended operations and Iran’s sanctioned exports impact c.5% of the global iron ore supply. Add on top, Anglo’s dependence on the Brazilian regulators for permitting a capacity increase at its tailings dam used for Minas-Rio – impacting another c.20mt of output, at present, a total of c.6% global supply is at risk.

The April 2019 lower court ruling pertaining to Brucutu had suggested that the Brazilian regulators and the new government were probably taking a somewhat lenient view of the current situation – especially given the strategic-importance of commodities in Brazil’s export and tax revenue, and, hence, there could be an easier way out for miners like Norsk Hydro – which is also accused of environmental negligence.

However, the ground reality hasn’t changed at all. Remember, even the claims with respect to the Samarco (BHP-Vale iron ore JV) tailings dam disaster, which happened in late 2015, haven’t been settled to date. Overall, the safety-related scrutiny at tailings facilities is set to heighten globally and may eventually result in (material) incremental compliance costs.

Even though the on-going fears have resulted in a gradual run-down of low-grade Chinese port inventories, and the discount on low-grade ores narrowing vs. high-grade ores, sustainability of this trend is questionable. Remember, with excessive pollution and sustainability of the (State-backed) zombie steel sector being key Chinese concerns, the switch to low-grade ores may only turn out to be a near-term remedy.

Instead, the high-grade miners should benefit eventually. Rio’s unit cost competence and almost calamity-free operations would place it ahead of BHP – against which a new $5bn lawsuit has been filed in the UK pertaining to the Samarco disaster. While Anglo also stands to benefit from the restoration of normalcy at Minas-Rio – after a pipeline leak resulted in suspension of operations for the most part of 2018, its dependence on successfully seeking a Brazilian permit (as discussed above) – which may be difficult in the current environment, and the uncertainties associated with other businesses, especially in South Africa, increases the risk quotient.

The recent spike in iron ore prices warrants some upward revision of our estimates.
Although, the upside on the respective stocks may not increase materially, given the unaddressed trade concerns. However, buying on (macro) uncertainties-induced corrections could offer better entry opportunities. Remember, unlike the last period of market turmoil, most large-cap miners have successfully strengthened their balance sheets via the implementation of aggressive restructuring measures.