Iron ore – the Big Top or just a Big Blip

First up - Don't get too emotional about your big holdings in BHP or RIO or FMG (or other iron ore stocks) today - don't worry - we're going to wake up to iron ore up 20% one day soon. It's a market, it's not the end of the world. It is all about exploiting this sell-off, not getting rid of long term holdings in quality stock with record low PEs and big yields.

The iron ore price is down 15% overnight and down 44% from the top. Why?

Technically there is no argument - this is a break of long term support.

Stephen Barthomeuz wrote a good article about it in The Age yesterday and there are a host of articles today. Here are the main takeaways:

  • Steel demand in China is weakening. Steel prices also fell overnight.
  • Demand for construction steel is down on weaker property and infrastructure demand - it had to happen one day - you can't build a City the size of Brisbane every three months indefinitely. 
  • The Chinese are cracking down on leverage impacting the property and construction sectors in particular. This is a factor that is likely to linger. These are the sectors that require the most steel.
  • The Chinese economy is slowing. Industrial production, retail sales, investment and employment numbers all recently came in below expectations. The government are clearly concerned and have responded by relaxing reserve requirements for banks in an attempt to pump liquidity into the financial system and improve access to credit and put a safety net undergrowth.
  • China produces 1/3 of global carbon emissions and has committed to achieving peak emissions by 2030 and net zero by 2060. Steel production counts for 15% of those emissions. It is being targeted by authorities.
  • Chinese Steel mills are being told to reduce production. Tangshan for instance accounts for 8% of the global steel production and they have been told to reduce their output by 8%.
  • Chinese authorities have mandated total steel production shouldn’t exceed last year but production was up 12% in the first half suggesting a significant drop is needed to hit those targets in the second half.
  • China is holding the winter Olympics in February next year and is determined to reduce pollution so production restrictions will remain in place at least until then.
  • The Chinese are trying to reduce speculation in commodities, prevent hoarding and reduce demand and as a result have made threats and taken direct action through export taxes, cancelled rebates of VAT and have released some strategic reserves. The Chinese have realised that the most effective measure to cap iron ore prices is to put this ceiling on steel production.
  • Automakers are cutting back on production because of chip issues - A new Covid outbreak in China (Delta strain) has created supply chain issues for a number of products most notably semiconductors. This has had an impact on steel users like automakers. You might have seen the headlines this morning - Toyota to cut September global production by 40% from previous plan (Nikkei) - Volkswagen says it may have to cut production further due to semi supply crunch (Reuters) - Ford to temporarily shutter production at US truck plant due to chip shortage (Reuters).
  • The Covid outbreak has also now started to interfere with ports, shipping and containers, factories causing port congestion and disruption to the smooth passage of all sorts of products, like cars, products that use steel. The Chinese had to close a terminal of the third-largest container port in the world and it is still closed. All this flows back to manufacturers forcing them to reduce their own output with obvious consequences for the demand for raw materials.
  • Supply increases - Vale in Brazil is stepping up production and China is fast-tracking the development of the Simandou iron ore body in Africa.
  • The AFR reports that Platts reports that RIO "started offering a 170,000 mt cargo of Pilbara Blend fines for loading September 4-13 on COREX at $US151.00/dmt CFR China basis 61 per cent iron content on August 18, before dropping to $US131.65/dmt on August 19, without finding a buyer".

Bartholomeuz concludes - The disruption is short-term but the carbon emissions focus, the ceiling on steel production, the drive to reduce leveraging major steel consuming businesses and the intention to find new supplies of key commodities is longer term.

As I have written a number of times, no matter how cheap the stock, no matter how good the results, no matter how big the dividend, no matter what brokers think, the correlation between BHP, RIO, and FMG and the underlying commodity prices, particularly iron ore, will dominate. The share prices are going to follow the iron ore price and as that falls over, the stocks will as well. Despite great results and a dividend being due from BHP (RIO is Ex already - FMG Results on August 30), that’s what’s happening now.

A lot of you will be 'feeling' trapped in BHP at least until September 2 when it goes ex-dividend but some of you more experienced hands will know that franking is not the be-all and end-all and that share prices (especially in an overbought market) tend to lose the dividend and franking when they go ex-dividend anyway, so there's no benefit collecting the dividend most of the time, in which case you are not trapped at all. Why hold for a dividend and franking if you lose more than that in capital.

Bottom line - It's all about the timeframe - short term, none of these stocks can defy gravity whilst the iron ore price falls over. If you are an active engaged investor I'd be selling and watching. This could be a "Big Top". For investors (time horizon beyond the year end) - It’s going to be a buying opportunity  (not yet). Look for the bottom/the bounce. If you're cheeky you might even manage to catch a short term bounce and get into BHP ahead of the dividend if you're that obsessed with franking.

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