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Iron ore sector faces supply quagmire

Aussie miners are scrambling to meet Chinese demand.

Senior Digital Journalist, Your Money

Iron ore prices are set to surge this week as China’s holiday season comes to an end, but analysts believe the recent dramatic fall in supply could present a number of hazards for investors.

The price of iron ore – one of Australia’s most important exports – typically spikes at this time of year as China’s market re-opens for business after its annual week-long Chinese New Year festival.

However, prices have already been unnaturally high following a fatal mining catastrophe in Brazil two weeks ago, that saw Vale, the world’s biggest iron ore producer, closing a number of its operations and driving down supply.

Such a rally is unusual at this time of year, with demand for the commodity typically falling as the country’s steel mills wind down operations in the winter months leading into the New Year period.

As steel demand dies off in China, Australia’s export of iron ore also falls, both in terms of the volumes we sell as well as the price we can sell it for.

However the unexpected drop in supply could see prices jump to their highest level in five years, at more than $100 per tonne, as early as this week, according to mining analyst Vivek Dhar of the Commonwealth Bank.

Dhar told Trading Day that given the predicted increase of steel production from China and news that Brazilian regulators have overturned Vale’s mining license, a supply shortage of iron ore could be on the cards for at least the next six months.

“Now we’re seeing the price reaction and this is where we’ll really find out just how much those steel mills are willing to pay for iron ore, simply because this is the time of the year they start to boost steel production for the construction season,” he explained.

The sudden change in supply has left Australia’s big miners – Rio Tinto, Fortescue and BHP Billiton – “scrambling” to fill the gap by increasing production. But Dhar said it’s unlikely to be enough to fully meet demand in the months ahead.

“They’re near their capacity… Anything above their plans will be difficult. So this shortage will really be felt. And this spike, we believe, will be there for about two to three weeks. We should see a supply response hopefully from Vale in the next six months… but there’s a lot of risk to that outcome,” He said.

Low profit margins among China’s steel mills will mean iron ore prices could soon flatten if China simply decides it’s too expensive to keep buying.

“We think low Chinese steel margins will limit the duration of any price spike,” he told Yourmoney.com.au. “Steelmakers face higher input costs and that can infiltrate the supply chain.”

The scenario presents a risk for overzealous investors of the industry in the coming weeks.

What makes the situation more difficult is the lack of clarity around the future of production, with Brazilian regulators having overturned Vale’s mining license indefinitely in what Dhar calls a “legal nightmare” for the company.

“This quagmire that Vale is in is something that could see those 30 million tonnes [of iron ore] sidelined for a very long time.”

Vale is expected to cut down on the production of around 40 million tonnes of iron ore production this year, according to Reuters.

That could see the miner dethroned as the top producer and pave the way for its biggest rivals – Rio Tinto, BHP Billiton and Fortescue.

Watch the full interview with Vivek Dhar in the video above.

Read more: How Brazil’s mining tragedy could shake up Australia’s iron ore market
More: How Chinese New Year affects our economy
More: The 3 threats facing Aussie miners

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