Iron ore set to stay ‘stronger for longer’

The case for iron ore prices staying “stronger for longer,” as bulls for the steel-making commodity predict, has strengthened as new mining projects are pushed back and demand remains robust.

But investors are cautious about paying up for shares in the big iron ore mining companies like Vale of Brazil, the world’s largest iron ore miner, Rio Tintoand BHP Billiton. Nor are they bidding up the nascent iron ore swap market.

These lower prices are years in the future. But miners’ valuations are pricing them in now. Vale, for example, trades at a multiple of 5.7 times forecast earnings for 2011 compared to an average of 7.7 times for peer diversified miners, according to RBC estimates.The consensus view has been that today’s spot ore prices of $175 per tonne will fall to $100 by 2014 as supply grows, before settling around a long-term range of $60-80.

Many analysts attribute the so-called “iron ore discount” to expectations of a glut as soon as 2014. But some say the glut will not materialise by then and that prices will stay closer to current levels for years.

The swaps market, where investors such as hedge funds trade views on the future cost of the commodity, is not as bearish as the equities market. Still, ore swaps for 2014 delivery price the commodity at $130, down 25 per cent from current levels.

The big iron ore miners, looking forward to years of strong earnings, are puzzled by their valuations, as are some equity analysts.

There is a “complete disconnect” between iron ore miners’ valuations and iron ore price assumptions, says Tim Huff, at RBC Capital Markets. Ephrem Ravi, at Morgan Stanley, says the discount is “too sharp,” while Richard Knights of Liberum Capital says it is “too extreme”.

The consensus view about a rapid drop in prices has started to fracture as the list of delayed new mining projects grows, production costs in China surge, and India, the world’s third largest producer of the commodity, curtails exports.

The latest additions to the delayed projects include Vale, which cut its iron ore production target for 2015 by around 10 per cent, and China’s Sinosteel, which suspended work on a A$2bn iron ore project in Australia. According to BHP Billiton, miners said in 2008 that they would add almost 170m tonnes of new supply. But they only delivered 26m tonnes of that. Last year they forecast a wave of 500m tonnes would arrive, but new supply was half that, at 234m tonnes.

Production costs are rising, too, supporting prices. The cost of digging iron ore in China has surpassed the $120 a tonne level, up from around $50 a tonne a decade ago. Mr Knights says that, when the price falls, the high-cost Chinese producers will be driven from the market, taking with them a large chunk of today’s supply.

Also, India is exporting less iron ore as it diverts local supplies to feed its own steel industry and clamps down on illegal mining. The unexpected reduction, which appears to be permanent, has tightened the ore market.

Colin Hamilton, at Macquarie, summarised the problems in a recent note: “No shortage of supply struggles.” Guilherme Cavalcanti, Vale’s finance director, told the Financial Times in a recent interview that prices would remain above $150 per tonne for the next five years due to supply problems and strong demand.

For now, though, miners’ shares and iron ore swaps show investors are not yet ready to bet the commodity price will remain as high as analysts and executives believe.

Among London-listed miners, Rio, the world’s second-biggest producer, is most exposed to iron ore. Ore sales would generate 70 per cent of this year’s underlying earnings. But its shares have traded sideways despite upward earnings revisions.

While investors in iron ore swaps maintain a relatively bearish view, there are signs that some are, slowly, starting to bid up the market.

Spot prices have barely moved since the beginning of the year, but the iron ore swap for delivery in December 2013 has risen nearly 10 per cent to $140 since January. For bulls, that is a sign some “savvy” money has changed its mind.