“Every day's a good day in Australia.” - Paul Hogan
When we first started to study China, we identified early on (thanks to Michael Pettis) the dependence of commodities exporting countries to the Fixed Asset Investments in the Middle Kingdom. Australia was standing out as one of the most at risk and iron ore has the poster boy for this commodity boom and bust.
In mid-2011, we wrote about about Australia’s large exposure to China. Steve Nguyen followed up with two articles about Sino-Australian trade (2013) and Australia’s iron ore exports to China (2014). Nicolas Houillez then addressed China’s trade war in the mining & metals industry in 2015. As a result, except for 2012, we’ve consistently published about iron ore, China and Australia.
Here is our latest research on the Australian’s iron ore industry prospects. The IMF metals index has already fallen 76% from peak to through; iron ore prices, one of the most used metals, decreased by 80%. Most of it is due to uncertainty in Chinese demand, which accounts for over 60% of world iron ore imports. In this article, we will see how it impacted Australia.
First, we will review the global market situation before diving into the Sino-Australian trade relationship and focusing on the impact of China’s slow down on Australia. We will see that beyond the end of a cycle, it is Australia’s economic situation that is at risk.
The age of iron: an industry dominated by giant trinities
Iron ore is actually the 4th most abundant element after oxygen, silicon and aluminium and, after aluminium, the most abundant and widely distributed metal. It represents about 95% of all metals used per year and 98% of iron ore is used on steel, an alloy used in a wide variety of industries.
In fact, steel can be considered as a basis for the industrial world because of its key role in infrastructure and thus overall economic development. As a result, the steel industry is usually regarded as an indicator of economic progress, which may explains the obsession of some emerging countries to produce the treasured alloy.
Because of its importance and abundance, iron ore is considered a true commodity: high volumes, low prices. However, mining iron ore requires very high capital investments and as a result a limited number of companies control the iron ore market, with 3 companies dominating: Vale, BHP Billiton and Rio Tinto.
The 3 main countries for the iron ore market are China, Australia and Brazil, accounting for some 82% of the world’s total useable ore production in 2015. China is both the world’s largest producer and the world’s largest importer of iron ore. Australia is the world’s largest exporter, accounts of 54% of the world exported volume in 2015, while Brazil is the second with 25%.
After several years of stagnation, iron ore production started to pick up in 2003 and then grew at an average of 10% annually through 2014. Chinese demand was the primary driver for the production increase, thank to an infrastructure and construction boom propelled by an imbalanced economy. Since Chinese iron ore quality is on average much lower than international standards (33% Fe content in 2003, 17~20% in 2015 vs. world standard of 62%), large producers were able to export a large part of their production to the Middle Kingdom.
Indeed, both Brazil and Australia increased their domestic production and their exported volume to China, benefiting from an increase in prices as demand outgrew supply. Companies then ploughed back their earnings into capital investments to answer the demand, launching new mining projects to increase production volumes.
However, after a decade-long boom in commodities prices, China’s slowing GDP growth have hurt commodities exporting countries hard. Iron ore is one of the most affected, with a 80% price decrease between February 2011 and December 2015. It has since rebounded and continues to fluctuate due to a mix of speculation and somewhat worse than expected Chinese macroeconomic data.
As we will see, Australia is particularly exposed to China’s slow down, largely because of its iron ore exports. Even though Chinese iron ore is of lower quality and should be displaced by higher quality ores from Australia or Brazil, the Chinese government chose to keep domestic mines operating, most probably for strategic reasons. At the same time, large foreign miners were ramping up output to squeeze out Chinese miners. Politics is currently overriding economics and as a result prices are most likely to decrease further. In the next part, we will dig deeper into the Sino-Australian trade relationship.
Australia-China iron ore relationship: feeding the dragon
Australia iron ore export volume to China are almost 10x higher than its next largest client, Japan, whose imports remained stable between 1990 and 2015. Overt the same period, China’s share of Australian iron ore export volume increased from 24% to 82%, while Japan’s declined from 43% to 9%. This shift underlines the rapid economic growth of China, driven by the buoyant growth of its construction and infrastructure spending.
At its peak in 2014, iron ore exports to China accounted for 17% of Australia’s total export value of goods and services. Back in 2001, it was only 1.5%. In 2015, this lucrative trade fell down due to a slow down in Chinese imports combined with a decrease in prices. Some USD 27 billions were shaved out of Australia’s total exports, which accounts for 44% of Australia’s export decline over the same period. In fact, over half of Australia’s 24% decline in exports value in 2015 is due to the combination of import volume growth slow down and price decrease.
From the consumption side, China sources 2/3 of its iron ore imports from Australia. Like most countries, almost all of it goes into steel production. The biggest users of steel are the construction sector and the equipment manufacturing sectors. However, given the rapid decline of Fixed Asset Investments’ growth, demand for steel products is evaporating. Chinese steel mills are facing massive overcapacity yet keep rolling out products in a desperate attempt to show a profit.
In addition, given the massive overcapacity of China’s steel factories and the high iron ore inventories at Chinese port, it is unlikely that prices will remain high. We may even see Australia’s export volumes decline with the removal of excess steel production, the clearing of excess iron ore inventories and the decrease of China’s Fixed Asset Investment’s growth. A perfect storm is brewing for the iron ore market: decreasing demand and high inventory are meeting an ever bigger production volume.
Australia iron ore industry: halfway down the stairs
About 95% of Australian iron ore is mined in Western Australia (WA), a state relying on export of raw materials and commodities. WA is in fact the largest iron ore producer in the world, accounting for 37% of total world production and 52% of world total exports. Since no major steel making operations are located in WA, almost all the iron ore extracted is exported abroad.
Only 3 companies accounted for 90% of Australia’s iron ore production in 2014: Rio Tinto, BHP Billiton and Fortescue Metals Group. Rio Tinto and BHP Billiton are large commodities producers with a portfolio including commodities such as other minerals and energy products (coal, petroleum). On the other hand, Fortescue is pure player, 100% focused on iron ore production.
With the decline in iron ore prices, BHP Billiton restructured its company by spinning off non-core assets into a listed vehicle (South32) in October 2015, which already recognized a USD 1.7 billion asset impairment and a USD 1.5 billion pre-tax loss. Rio Tinto publicly denied assets sales for now, though in any case bids would be as low as commodity prices. Meanwhile, Fortescue focuses on aggressively cutting costs.
As part of companies’ cost cutting measures, a dramatic reduction of workforce has taken place. Australia’s mining industry employs about 2% of the country’s total workforce (up from 1.4% in 1984) or 222,000 persons in August 2016. At its peak in May 2012, it employed 2.4% (or 271,000 persons) of Australia’s workforce, meaning it already shed 20% of its workforce over 4 years. Given the low prices, overproduction and high inventories, we can expect more cuts over the coming years.
Australia’s iron ore industry employs over 30% of Australia’s mining workforce. It already reduced its number of employees by 30%, from 96,000 to 67,000. Rio Tinto, BHP Billiton and Fortescue cut their workforce by 23%, 47% and 60% respectively (including contractors and spin offs). CAPEX have been reduced at their minimum while impairments are increasing (USD 6 billion globally). Yet, with lower cash flow to service debt we can expect additional cuts in coming years.
In terms of equity performance, Australia’s Metals & Mining sector is the largest industry sector by number of companies, with over 650 companies involved in mining or related services as of June 2016. But this number is down from 742 in December 2013, and in spite of some 290 new companies listing since 2009. Even though the number of companies is large, a few relatively small number of companies dominate the index: of the 100 largest companies by market capitalization, the largest 5 account for 75%.
The index followed the fluctuations of the commodity prices, rising thanks to the rebound driven by the Chinese stimulus before gradually falling since mid-2011. It remains to see whether the recent rebound since early 2016 will last.
Miracle or mirage? The long term impact of China’s slow down on Australia
As we have seen, Australia’s iron ore industry already started to restructure its operations and cut costs while share prices have declined on the back of lower prices. While additional cuts in headcount can be expected in iron ore and coal mining as companies restructure, merge and automatize their operations to weather the decreasing prices, a large part has already been done.
However, when prices started to decline in fall 2011, Chinese iron ore imports continued to grow. Between September 2011 and June 2016, Chinese import volumes increased by 45% while prices declined by 70%. This helped companies offset some their pricing losses. But China’s import growth is dependent on real estate and construction spending, which is itself relying on credit growth.
The latter has been growing at an average of 20% annually since 2007 and total debt is now 250% of GDP. Rapid credit growth is a warning sign for a debt crisis as productive investment opportunities are limited and debt starts funding financially unviable projects. Debt payments can then be refinanced with cheap loans. It continues until investors’ confidence in the system decreases and the domino-like structure of debt collapses as refinancing rates increases or unviable projects are refused credit extensions.
If Chinese demand for iron ore stagnates or even decreases, no other country will be able to lift up demand and plug the offer/demand gap. Indeed, currently none has the size, the infrastructure deficit or the deeply imbalanced economic structure of 1990’s China to create a driver that would replace Chinese demand. If anything, Trump’s plans to rehabilitate America’s infrastructures may benefit from the fall in raw materials, but are unlikely to maintain prices high.
A case in point are the BRICS (Brazil-Russia-India-China-South Africa) which were once hailed as independent from Western business cycles. Except India, all of them are now in economic crisis due to China’s economic slow down which led to a sharp decline in commodity prices.
Given Australia’s large share of commodities export to the rest of the world (and especially China), one of the most visible effect has been the decline of the Australian Dollar against the US Dollar. The currency already declined by some 25% from its July 2011 peak. While this may make Australian commodities more attractive, the oversupply due to lower Chinese demand is likely to be a stronger force than depreciation. In any case, expect lower earnings.
In turn, the decline in commodity prices, exports volume and exchange rate may also have a larger impact on internal consumption. It appears that with the commodity boom, Australian households, private sector and governments have increased their debt levels. This is worrying because to reduce one of the three sector’s debt load without impacting GDP growth (all other things being equal), another sector should leverage proportionally.
If the commodity crunch continues, debt loads may increase as revenues and cash flows decrease, potentially kicking powerful debt deflation dynamics. Another issue is the rapid growth of total debt, with an average of 8% annually. The household sector looks particularly at risk with a relatively constant annual increase of 10% between 1988 and 2015.
On top of this, Australia is apparently experiencing a housing bubble. Number of dwellings other than houses (apartments) approved for construction and total value of residential building increased dramatically since early 2014. This bubble started as the infrastructure spending linked to the commodity bubble began to deflate.
So beyond the impact of iron ore price decrease, it is the whole Australian economy that is facing potential hurdles. The commodity bubble probably triggered a larger credit bubble, thanks to a massive influx of money from metal ores exports. Now that the flow reverts back to historical levels, the sustainability of Australia’s own imbalances is uncertain.
Conclusion: beyond iron ore
As we have seen, Australia’s iron ore industry has been actively restructuring since the 2011 price peak. But iron ore prices are still 4x the historical average of USD 12.8 /dmt between 1985 and 2004. Given the oversupply and the stagnation (or even decrease) in Chinese demand, prices can continue to fall. The real driver is China’s leadership management of credit growth: the stop and go approach that has been keeping rapid growth rates since 2009 is unsustainable and ultimately increases the size of the debt problem.
For Australia, beyond additional job cuts in the iron ore industry, wider economic risks such as rapid leverage of the household sector and a housing bubble give the government little room for manoeuvre. Cutting Australia’s central bank interest rate in the hope to sustain spending thanks to credit can only smoothen the impact of an inevitable deleveraging.
China’s import of soft commodities may alleviate some of the pain from hard commodities. Even though Australia has seen increased Chinese demand and investments in its agricultural products, China only accounted for 10% of its agricultural exports value, and 3% of its total exports in 2015. Using 20% as the average value growth rate of the highly fluctuating Australian agricultural products exports to China, it would take over 12 years for them to reach the 2015 value of Australian iron ore exports to China.
This assumption is certainly simplistic but it highlights our point: soft commodities are unlikely to replace hard commodities. The commodity cycle is over because of China’s slow down. On the bright side, Australia’s iron ore industry will remain the world’s largest for the foreseeable future: the infrastructure has been built, the country holds enormous reserves of quality ores, and its companies have competitive costs structures. But the country still needs to cope with the headache of managing the hangover from the end of a massive commodities cycle.
In fact, going further beyond iron ores and other commodities exports, it is Australia’s relationship with China that needs to be defined. What kind of political partnership can they build? What is Australia’s place in the Asian continent? How can this ‘small’ (by population size) Western country fit into the buoyant Asian powerhouse? It certainly cannot remain only a commodity producer feeding the economic growth of emerging countries or a safe haven where rich Chinese families hide their wealth by buying up real estate. Yet what will happen when Australia goes through the pain of restructuring itself as its various bubbles deflate?
About Carlito Riego
"Great perfection may appear imperfect, but its usefulness is inexhaustible. Great abundance may appear empty, but its usefulness cannot be exhausted. Great correctness may appear twisted, great skills appear crude, great eloquence appear awkward. Activity conquers cold; inactivity conquers heat. Clear serenity governs the world." - Lao Zi