Sunday, 27 May 2012

Australia and the Iron Ore conundrum

"The most fatal illusion is the narrow point of view. Since life is growth and motion, a fixed point of view kills anybody who has one."
Brooks Atkinson

Following up on our recent Shipping conversations ("Shipping is a leading credit indicator - A follow up"; "Shipping is a leading deflationary indicator"), we thought we would venture towards "Down Under", namely Australia given the recent weakness of Chinese Iron-Ore Inventory which have been declining for four weeks and are now below 2011 highs represent a serious conundrum for Australia's economic growth in general and AUD-USD in particular.
Source Deutsche Bank Shipping Weekly - 21st of May 2012

In fact since the beginning of the year both the Brazilian Real as well as the Australian Dollar have experienced a significant weakness versus the US Dollar - source Bloomberg.
While both commodities depending currencies had moved in synch versus the US dollar, the correlation between both broke last year leading to significant divergence between both currencies.
In a recent note entitled "Iron Ore Summer Slowdown" published by Deutsche Bank, their analysts indicated the following:
"Iron ore exports from Brazil have disappointed. Export levels have been poor due to various factors including adverse weather and infrastructure challenges. We expect that export levels are likely to exceed 25mt/month over the next couple of quarters. This normalisation of Brazilian exports could put additional pressure on the market as well.
Certainly we would expect that both Brazilian and Australian producers will be sensitive to the demand requirements of their customers, Europe and China principally, who we expect will be under considerable pressure over the summer slowdown period. On this basis one would expect that exports may drift lower in response to this. Nevertheless we believe that the ability of the key suppliers to ship tonnage to market will improve over this time-frame."

As Dylan Grice put it in his note "Australians be worried: someone is calling your country a miracle!" from the 25th of April:
"Australia's two biggest commodity exports are iron ore and coal. According to the RBA Australia has increased its iron ore capacity by 150Mtpa in the last five years, from 300Mtpa to 450Mpta. Planned capacity increases over the next five years amount to a further 200Mtpa (see chart below). Nearly all of it will go to China to feed the burgeoning steel industry there. But how healthy is China's iron ore demand? If its steel prospects were so attractive why does Wuhan Iron and Steel for one think pigs are the future? Why has the company recently announced plans to invest nearly $5bn over the next five years in industries in which it has no expertise, such as pig, fish and organic vegetable farming? Probably because steelmakers are now loss making and there is excess capacity. And if they have no confidence in the Chinese steel industry, why should Australia?"

In fact Deutsche Bank analysts in their note "Iron Ore Summer Slowdown" remain cautious near term:
"DB steel analysts in China are cautious near-term. After average daily production volumes reached 2.03mt/day in April, utilisation rates are now starting to moderate as end-use demand fails to materialise. In fact we understand that fabricators have high levels of finished inventories. Furthermore, steel inventories while falling are being drawn down at a slower rate than is usual for this time of year."

China growth cooling and implications for Iron Ore:
"Our China steel team expects that Chinese steel production growth will average nearly 4% YoY in 2012(reaching 710mt), as compared to 7.3% growth last year. Utilisation rates are forecast to fall to 86% in 2012.
However we anticipate that these figures may be downgraded if in fact a Chinese economic recovery is delayed or if GDP growth is lower than anticipated. We have concerns about the weakness of the three major fixed asset investment (FAI) pillars (infrastructure, real estate and manufacturing). As our team has indicated previously, excessive manufacturing growth in 2011(which was the highest since 2006) is worrying as it potentially sets the stage for a capex down-cycle for the sector in 2012. Of note, the aggregate capex for Chinese companies under DB analyst coverage is projected to decline in 2012." - source Deutsche Bank.

As indicated by Reuters on the 24th of May:
"Spot iron ore prices have fallen to a 6-1/2 month low below $130 a tonne this week, as steel mills in top consumer China deferred shipments and curbed fresh buying after domestic steel prices hovered near their cheapest in half a year.
Plummeting steel prices, which have shed 6 percent in May, coupled with doubts about domestic demand, are keeping China's army of steelmakers on edge, making them reluctant to commit to new orders.
With growing uncertainty over whether iron ore prices will continue to drop, Chinese steel mills have been picking up material they do need from ore piled at ports rather than making forward bookings with miners, which can take at least 20 days to arrive from Australia."

From the same article:
"If prices were to hit $120 a tonne, it could lead to the closure of some high-cost Chinese miners."
Source Deutsche Bank - "Iron Ore Summer Slowdown" - 17th of May 2012

It's still a game of survival of the fittest in this deflationary environment...

And as Dylan Grice put it in his note focusing on Australia:
"If Chinese resource demand holds up everything will probably be fine. But if it doesn't, well, everything won't be. In fact, there might be trouble anyway. The improvement in Australia's terms of trade (the ratio of its export prices to its import prices) has been spectacular thanks to the bull run in commodities. It should be running large current account surpluses, like Norway. But it isn't. It's running a deficit of 3%. So the AUD is overvalued and vulnerable."

Hence our negative view on Australian Dollar.

"All truth, in the long run, is only common sense clarified."
Thomas Huxley

Stay tuned!

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