Iron Ore: To the Core?

Posted: 7th May 2017

By: Clinton Chau

Have you ever tried to predict the movements in a commodity’s price? Ever wondered what effects of these price fluctuations are? Ever wondered what stock on the ASX is a pure iron ore player and how it has been affected by price fluctuations? Read into UNIT’s most recently published article to find out more!

Overview

Price fluctuations in commodities such as iron ore have an immense impact on the global economy. Australia is particularly reliant on this commodity as iron ore totaled US$48.9billion in 2016, accounting for approximately 25.8% of Australia’s total exports. This is a staggering 56.5% increase since 2009 and has lead to the creation of ASX listed companies which have seized the opportunity in this growing market. Given the impact of iron ore exports, an analysis of past commodity price trends and future projections can give readers an eye into the future performance of these companies.

History and long term Prospects for Iron Ore prices:

Source: MarketIndex

Prior to May 2005, iron ore prices always traded below US$15/ ton. The commodity subsequently rallied on the back of strong Chinese demand, peaking at US$191.80 in 2009 and capping an astonishing 13-fold rally over a five-year period. This was fuelled by increasing demand from China as iron ore production supplied steel for the construction of infrastructure in emerging economies such as China. This increase in demand benefitted Australia boosting the value of iron ore exports and resulted in a phenomenon called ‘the mining boom’. The mining boom peaked in 2012, after which iron ore prices fell by over 75% due to oversupply, bottoming out in 2015. The commodity currently trades at US$69.97/ ton.

An in-depth analysis into Iron Ore and its effect on stock prices:

Source: YahooFinance

Since June 2016 where iron ore prices briefly dipped below US$50/ ton, prices peaked at US$94.80/ ton in February. Prices have subsequently fallen since with the commodity losing around a third of its value to close at US$68.00/ ton on the 28th of April 2017. The effects of rapidly fluctuating iron ore prices have been felt most by investors trading pure iron ore players on the ASX such as Fortescue Metals (FMG). FMG was valued at AUD$3.50 in June 2016 but hit a high of AUD$7.27 in February following the iron ore rally, before declining to AUD$5.27 as at the 2nd of May 2017. The latter decline coincided with steep falls in iron ore futures; FMG’s concentration in iron ore increases the volatility of the stock as, despite a successful cost cutting program, the long-term survival of Fortescue is dependent on demand for iron ore. The underlying reason facilitating recent declines in iron ore prices are due to legislative changes in China that has curbed the borrowing capacity of companies engaged in the construction sector. Thus, the supply of iron ore in the Chinese ports is high with the intention of reducing by 50 million tons before end of 2017. Prices for the commodity are expected to decline towards the US$55/ton mark and hold this value throughout 2018. Consequently, we are likely to see a further decrease in Fortescue’s share price in the near future.

The primary reason that iron ore prices share such a strong correlation to the share prices of miners is the practice of valuing companies on the basis of expected future cash flows. Higher commodity prices on global markets increase corporate profits, boosting dividend payments share prices across the industry. Nevertheless, the question remains as to whether iron ore prices will continue along this downtrend or stabilize and resume their rally. It is useful to note that the primary factor affecting iron ore prices is global economic growth as iron is used primarily within the construction industry and relies on the continued success of large economies such as China. Construction giants such as Greenland who possess a debt to equity ratio of approximately 300% may collapse if credit growth remains unchecked and resulting in supply shocks to China’s already overheated property market. This is supported by Chinese banks who fear an incapacity for investors to repay their loans, hence having tightened their lending policies to both domestic and foreign investors.

The recent slowdown in China’s economic growth has had a large impact on the Australian economy. The question that still remains as to whether China’s economy will ever reach such high levels of growth again which they have experienced over the last few years or will the growth rate slowly continue to decrease. This is a crucial factor which must be considered as China accounts for over a quarter of total global GDP growth, and hence, will iron ore prices go back to the core?

How will Iron Ore Prices affect the rest of the Economy?

Although the fluctuation in iron ore prices impact companies which export commodities most, it can have a lasting impact upon other sectors of the economy. This is due to how highly global markets are interrelated whereby the value of the AUD can change the competitiveness of Australia’s exports compared to alternatives offered from overseas competitors. This can be attributed to the changes in valuation of the AUD whereby it reached a peak of 1.10 in 2012 (peak of Australia’s mining boom) but decreased to 0.67 (bottom of the mining boom). So with the dollar fluctuating and affecting the competitiveness of other sectors, the question remains to whether iron ore prices will boom or bust?