On 18/11/2011 the Metal Bulletin Iron Ore Index (MBIO) listed the price of iron ore at a heavily discounted $145/tonne, up sharply from the low hit at the end of October of $115/tonne.  However this is still well below the average price for September 2011 of $177/tonne.  

Can the price head back down to the late-October lows, or even lower still?  In August with the price over $175/tonne, some analysts were predicting the slowdown in China suggested a possible floor at $140/tonne.  But the rate of decline in the month of October was staggering, with the price hitting $115 by the end of the month.  Here is a table of price movement going back over the past year:

Although it has bounced back somewhat after crashing 35% in a month, the volatility is troubling.  So what is going on?  Why the sudden and dramatic drop last month?  We can look to four issues impacting the price:

1.    Change in iron ore pricing mechanisms

2.    European debt crisis

3.    Possible Recession in the United States

4.    A “hard landing” in China

Iron Ore Pricing

For decades the price of iron ore was set by annual contract negotiations between miners and steelmakers.  As such, the price was not subject to the vagaries of the financial markets, as is the case with the price of oil.  After oil, iron ore is generally recognized as the world’s second most vital commodity.  Since iron ore prices were a truer reflection of supply and demand conditions, they were a good precursor of price movement in other commodities.

The pricing mechanism has changed and is still in transition.  This year, annual negotiations shifted  to quarterly contracts based on the spot market.  Two years ago Deutsche Bank established a swaps market, allowing financial speculators to get in on the action.  And in mid-August 2011 the Singapore Mercantile Exchange (SMX) unveiled to the delight of speculative investors everywhere the first global platform for trading in futures of iron ore prices.  The SMX reports a continued rise in the number of contracts traded since the inception of the platform.

It is too early to tell whether speculative money is impacting the price to a significant degree or not.  Some experts claim the combined effect of the changes in pricing mechanisms led to the dramatic price increases seen earlier in the year and to the recent drops.  Others argue supply conditions and global economic concerns are responsible.  The coincidence of the October swoon and the increase in swaps and futures markets bear watching.  For swaps we have some hard data.  Open interest on the Singapore Exchange (SGX) reached a new record high of 9,799 lots in September.  That represents 4.9 million tonnes.

European Debt Crisis

Of all the issues impacting sentiment towards future demand for iron ore, the situation in Europe is perhaps the most problematic.  Political squabbling within one country is difficult enough.  In the Eurozone you are talking about agreement among 17 different countries.  

The situation changes almost daily, with reports of progress driving markets up and reports of stumbling blocks driving markets down.  What the market wants is some sense of certainty regarding a solution.  However, bear in mind that even if leaders reach a solution, there is now concern that the proposed fix may have to go back for parliamentary approval in some Eurozone countries, most notably Finland.  This process could take months.  The risk here expands beyond the Eurozone economy into China.  Many investors assume the largest importer of Chinese goods is the United States when the truth is the Eurozone imports more.

United States Recession

A recent release of the minutes of the US Federal Reserve Board indicate continued economic expansion in September 2011, but at a modest pace.  The problem with many economic indicators from any governmental source anywhere is that they are backward looking and quite frequently the data they look at is subject to later revision.

An excellent example is the US Department of Labor report for US unemployment in August.  The market reacted with shock at the news the number of jobs added for the month was 0.  That report was a major contributor to August market declines.  The following month, the Department of Labor issued an “oops” statement, revising the number upward to 57,000 jobs added.

The consensus among most economic forecasters is that the US will avoid a recession, but growth estimates have been reduced.  Here is a table of consensus estimates of GDP growth for the US and other key economies for 2011 and 2012.  The numbers in () represent estimates as of July 2011, which have been revised in downward in every case.

Note these experts are not forecasting recession anywhere.  However, most commentary includes the caveat of a resolution to the European debt crisis.  Should that not happen, or if the solution leads to a new credit freeze, these forecasts will not hold up.  The truth is, right now, it is Europe that is holding the world hostage.

The Slowdown in China

There is no longer any question whether or not China is slowing down.  In the second quarter of 2011 China reported 9.5% growth.  Recently released figures for the third quarter show growth of 9.1%

However, the Chinese government steadfastly maintains that the slowdown is the result of their plan to reduce inflation.  Some investors agree and indeed forecasters still see 8.5% growth in 2012.  Will that be enough for China to continue to play the role of growth engine for the global economy?

Proponents of the “soft landing” scenario have other positive indicators to support the view China’s growth will not crash.  

•    Retail sales retail sales rose 17% in September.

•    Factory production increased 14.2%.

•    Inflation slowed to 6.1%.

•    The Chinese Federation of Logistics and Purchasing (CFLP) Purchasing Managers Index (PMI) increased to 50.9 from a September reading of 50.7.

As the world’s largest exporter of iron ore, Australians are especially concerned about decline in Chinese steel production.  Steelmakers in China are looking at Europe with increasing concern and reportedly have been cutting back purchases.  Recent headlines show miners like Rio and Brazil’s Vale ready to renegotiate contract prices.

Forecasters anticipated a decline in Chinese iron ore imports for the month of September.  Instead, they saw an actual increase of 2.5 million tonnes; with a total import of 60.57 million tonnes.  

However, with declining steel prices some experts still  predict a slowdown in iron ore imports.  They claim the recent surge was due to restocking in anticipation of the Chinese holiday.

Experts can be wrong and certainly have been during these challenging economic times.  The negative forecasters assume catastrophic events, such as a European crisis driven credit freeze.  To “back test” that view, we can look at the impact the GFC had on imports and exports in China.  Here is a five year chart showing total manufacturing PMI as well as PMI for imports and exports:

The chart clearly shows the impact of the GFC.  As you know, a PMI reading of 50 or above indicates economic expansion and China has been flirting with that line for much of this year.  If there is a GFC2, past history tells us what we might expect.

There is another lesson to be learned from the PMI chart above.  Note how quickly China rebounded from the GFC.  China and the world’s other emerging economies are not going away.  They will continue to need our iron ore to make the steel they need to grow.  The risks with the Australian miners are real, but the flip side of the risk coin is opportunity. 

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au. You should seek professional advice before making any investment decisions.

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