Pete Wargent blogspot

Co-founder & CEO of AllenWargent property buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place), and CEO of WargentAdvisory (providing subscription analysis, reports & services to institutional clients).

5 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the finest property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

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"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

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"Wargent is a bald-faced realty foghorn" - David Llewellyn-Smith, MacroBusiness.

Sunday, 23 November 2014

One Year of Iron Ore Carnage

Iron Ore Price Crash

As ever greater volumes of iron ore supply hit the market in response to a commodity price which had reached for the stars, the market appears to be more than a little flooded.

In November 2013, the average spot price for the month was sitting very pretty at above $135/tonne.

In the year since then the price has all but halved to ~$69.80 tonne. Some of the producers at the higher end of the cost curve will be feeling the pain now.


"Moats"

Experienced value investors will tell you that the outstanding companies to own shares in for long term returns are those which have an "economic moat" which protects them from their competitors.

For example, a technology company such as Intel for many years was able to carve out a wide economic moat for itself through retaining vastly superior microchip technology to its competitors.

Today the market for mobile chips and microchips which can navigate via GPS satellites moves on, and the challenge for Intel will be whether it can stay a step ahead on the game as the smartphone revolution continues.

Other companies have instead been able to build a "brand moat". 

Harley Davidson (HOG) motorcycles, for example, was able to protect its market share because, even though imitation bikes could made by Kawasaki and others, ultimately bikers wanted to own a Harley.

In the end Kawasaki would have to acquire Harley due to an inability to cross or break down this seemingly impenetrable brand moat.

Commodities

The problem with commodities companies is that they produce...commodities. 

Unable to differentiate themselves easily on their brand or their product, the main point of competition therefore is usually price.

This means that the large-scale iron ore miners with the largest projects and reserves - such as BHP Billiton, Rio Tinto or Roy Hill - have an inherent advantage in that they can produce at a significantly lower iron ore price per tonne.

Their "economic moat" is a lower production price per tonne of ore.

They can continue to pump the market with supply and accept lower returns per tonne for a time, a luxury rarely afforded to those at the bottom end of town who generally sit at the higher end of the cost curve.

Resources exploration and production at the smaller end of town is a rough-and-tumble type of industry, and the halving of the commodity price has pushed a number of Australia's iron ore miners close to or even beyond their break-even price in the prevailing environment.

Share prices have responded accordingly over the past year - if it isn't a race to zero for these more marginal companies just yet, we are only a month or three of declining spot prices away from it starting to quack like one...


The miners listed below have seen their 12 month share price charts record declines of between 50 and 90 percent, which reflects their respective break-even prices and potential to bring average production costs down.


Market Response

The Chairman's Address to Shareholders when companies have delivered such devastating shareholder returns forever make for uncomfortable listening or awkward reading.

In recent weeks some companies have highlighted their achievements in transitioning to production in the first place or ramping up volumes, despite the plummeting returns (great if you're on an executive salary, natch, not quite so enthralling for shareholders).

Other companies have discussed how the royalties paid on their exports have been equivalently enough to pay for schools, or discussed their other good works in the mining town communities.

The stonking great elephant in the room of course is what these companies are going to do about the uncomfortable prospect of operating at a loss.

The only real choices include the following:

  • to continue to squeeze or reduce cash costs and all-in production costs going forward;
  • to reduce volumes temporarily or mothball operations - a costly manoeuvre;
  • to hope that miners higher up the cost curve capitulate first slowing supply; or
  • to hope that iron ore prices rebound sharpish thanks to demand from China.

Chairman and CEO Addresses variously have alluded to each of these points.

Is the China Story Over?

On Friday China's PBoC pulled a surprise move by chopping interest rates. There was an initial bounce in a number of commodity prices, which then calmed.

It will be interesting to see how commodity prices, particularly iron ore, fare through the week ahead.

The Reserve Bank has been at pains to point out that China's unprecedented urbanisation boom has several decades still to run.

The central also highlights that while the headline rate of economic growth must inevitably become slower over time due to the sheer scale of China's total GDP, there will continue to be a "huge demand for commodities of many kinds" as China's economy continues to expand in size.

"Even if the sustainable growth trajectory for the Chinese economy gradually declines over the medium term, the economy is much larger than it was and is still growing. This implies there will continue to be a huge appetite for commodities of many kinds. 

Some of this demand can be satisfied by local Chinese production, but given the competitiveness of Australian production in a number of commodities, China is likely to be a large market for Australian resource exports for some time to come."

Graph 4: China - Urbanisation Rate

In that same "medium term", however, it seems likely that an element of iron ore production will be forced to the wall. The same seems certain to be true for some coal producers.

The big question domestically is where that pain will be felt? In other high-cost countries? Will some of China's own state-owned or private producers capitulate first (the data on this seems woolly, as does most information from China)?

Or will some of the higher-cost Australian operations be cancelled?

We have concentrated at iron ore above, that being the key bulk commodity in the RBA's index, but at this stage in the cycle but similar challenges face producers of a raft of different commodities, from copper to coal, to gold, silver and more.


With the Aussie dollar declining from above parity to 86-87 cents in recent years this has smoothed or stabilised the Reserve Bank's commodities index to a certain extent.

The RBA's index is down 17 percent in SDR terms (red line) in the past year to October 2014 and 13 percent in AUD terms (orange line), with more falls seeming likely to follow in November.

The two blue lines denote the rollercoaster ride for the all-important bulk commodities in SDR and AUD terms.

That's still all looking pretty messy any which way you look at it. From an exporter's perspective at least, an Aussie dollar in the low seventies would really be a big help!