Iron ore is Australia's silver lining to its darkening China cloud

In the midst of a bitter, escalating and rather one-sided trade confrontation, the price of our biggest export to China has just hit its highest price for more than seven years.

The iron ore price, while it was knocked around by the initial impact of the pandemic in March, has been climbing strongly ever since and has now reached $US136.29 a tonne, its highest level since September 2013 and nearly 50 per cent higher than it traded for at the start of this year.

The miners have, ironically, China to thank for that. More than 80 per cent of Australia’s iron ore exports go to China, accounting for 60 per cent of China’s supply.

While China has been happily slapping tariffs and other trade barriers on Australian products like coal, barley, lobsters and wine, it has left iron ore untouched, largely because it has no alternative either now or in the medium term or perhaps even longer.

Australia’s miners, notably Rio Tinto, BHP and Fortescue, dominate the seaborne trade in iron ore. Their main competitor, Brazil’s Vale, is still recovering from its tailing dam disasters and, more recently, the impact of the pandemic and heavy rains on its production.

Earlier this week, Vale lowered its forecasts for this year’s production by 5 million to 10 million tonnes, from an already-reduced target of 310 million tonnes.

That Vale-aided tightness in supply, which is expected to continue into the first half of next year at least, has coincided with a surge in China’s demand.

China’s response to an economic downturn is consistent. It injects massive sums into expanded investment in infrastructure which in turn flows into increased demand for steel.

It did that in response to the 2008 global financial crisis, sparking a historic boom in commodity volumes and prices that played a major role in the relatively modest economic impacts of the crisis on Australia.

It’s done so again in response to the coronavirus. China’s October steel production was 13 per cent above the same month in 2019 and, while slightly lower than the previous month’s output, was in line with industry estimates that the Chinese steel mills are producing at a record annualised rate of about 1.1 billion tonnes.

China’s response to the pandemic has worked, to a degree. It is forecast by most of the major international economic agencies to generate GDP growth of just under 2 per cent this year.

While well short of the 6.1 per cent growth rate last year, or the double-digit growth rates it achieved in the immediate aftermath of the financial crisis, any growth at all would make it the only major economy to end the year in positive territory.

It has long been a source of frustration and concern for China that it is so reliant on Australia for the most critical feedstock for its industrial base.

It has tried to diversify its sources of supply, pursuing economic and financial ties with Brazil to help promote its industry and lower its shipping costs and therefore reduce the competitive disadvantage of Brazil’s distance relative to the Australian miners.

It wasted billions to try to secure ownership of its own Australian supply in the mid-western regions of the Pilbara in Western Australia. It controls very large deposits of ore that it hasn’t, so far, been able to develop.

China’s response to an economic downturn is consistent. It injects massive sums into expanded investment in infrastructure which in turn flows into increased demand for steel.

It even got close to effective control of Rio when the biggest of the Pilbara miners nearly fell over during the financial crisis, before Rio eventually walked away from the controversial deal (which the Rudd government may well have blocked anyway).

The search for new supply sources hasn’t ended. Much has been written about the potential for the vast Simandou deposits in Guinea – more than 2 billion tonnes of high-quality ore with the “potential” to produce perhaps 150 million tonnes of ore a year – to displace or at least diminish the Pilbara’s strategic hold on China’s steel industry.

The resource, which has a colourful history, has tantalised a succession of potential developers, including Rio, which once controlled the entire deposit and spent more than a decade trying to work up a feasible plan for developing the two (of four) blocks that it has retained an interest in. That interest has been shared with China’s Chinalco. The other blocks are now held by a consortium of Chinese, Singaporean and French companies.

Even during the peak of the iron ore boom, when iron ore’s price was spiking up towards $US200 a tonne, the economics of developing the project proved difficult because it would require the building of a new port and, at the Guinean government’s insistence, a new 650-kilometre rail line through difficult terrain.

Rio estimated it would cost close to $US20 billion ($27 billion) to develop the mine and infrastructure for its blocks. The other consortium has put a price-tag of $US14 billion on the cost of its development.

Even if the two projects shared the transport infrastructure, the cost and complexity would be enormous and it would be more than a decade before serious volumes of ore could be sold.

History suggests both the cost and timelines would be significantly larger and longer than forecast even without the additional threat posed by previous outbreaks of Ebola in Guinea and the poor record of developing large-scale projects in African countries other than South Africa.

In the meantime, all three Pilbara majors – already highly efficient – are lowering their costs and expanding their production through incremental additions to the capital already sunk – and the infrastructure depreciated.

Simandou might have a very large deposit of high-quality ore but it won’t be at a lower cost than the ore Rio, BHP and Fortescue produce from mines and ports that have been operating since the 1960s.

Thus, for the foreseeable future, China might be able to impose bans on Australian products where it has alternative sources of supply and accept the increased cost and reduced quality from banning Australian coal, for instance, or the reduced consumer choice of the punitive tariffs on Australian wine, but it has no substitute when it comes to iron ore unless it wants to shut down its steel industry and economy.

Given that iron ore represents more than 40 per cent (and rising) of the value of our exports to China, that’s something of a silver lining within a darkening cloud.

https://www.smh.com.au/business/markets/iron-ore-is-australia-s-silver-lining-to-its-darkening-china-cloud-20201203-p56k7k.html