Is there more pain ahead for BHP, Rio Tinto and Fortescue investors?

Iron ore markets are off to a rocky start this month, with prices plummeting 4.1% on Monday to US$97 a tonne, raising concerns for major producers. This downturn comes in the wake of China's latest economic data, which paints a grim picture for the manufacturing sector.

China's National Bureau of Statistics reported that manufacturing activity hit a six-month low in August, with the purchasing managers' index (PMI) falling to 49.1 from 49.4 in July, below market expectations of 49.5. The decline was marked by deflating prices and persistently negative new orders.

For iron ore producers, the outlook is particularly bleak. The steel sub-sector PMI dropped to 40.4 from 42.5 in July, while the new orders sub-index plunged to a 15-month low of 38.5.

Singapore iron ore futures (Source: TradingView)

Where to from here?

Citi said their view about iron ore hitting US$85 a tonne in the next three months has received very little pushback from the investment community. However, this projection hinges on several factors and outcomes. The analysts tried to shed light on the key questions about where iron ore goes from here.

1. What declines in China steel demand do the different iron ore prices imply?

2. What data points/indicators should one watch to 'buy the dip' (or not)

3. What has surprised us in the last three months given the well-known macro weakness

How bad do things need to get for US$85 a tonne?

To reach US$85 a tonne, Citi suggests that China's steel demand would need to decrease by 6-9% from 2023 levels. This represents a significant downturn, considering that during the last major steel demand slump in China in 2015, production declined by 2.3% year-on-year, while apparent demand fell by 4.3%.

Despite the gloomy outlook, Citi's report offers a nuanced perspective: "The decline in steel demand given the weak macro in China is no surprise. In our experience, commentary on the state of the industry by companies and the press in colourful turns of phrase like 'prolonged winter', 'endless darkness' etc is usually more a sign of the trough than harbinger of a big leg down."

Demand indicators

• China's New Total Social Financing (TSF): July 2024 TSF increased 44% year-over-year, but the year-to-July TSF is down 15% year-over-year. If this trend continues, it could lead to the largest annual decline in two decades, with projections suggesting a 16% decrease for the full year 2024.

• China's Property Outlook: Floor space sales and starts declined significantly in both July 2024 and year-to-July, down -17% and -21% year-over-year, respectively. Citi forecasts an 18% decrease in sales and 22% decrease in starts for FY24, potentially reaching the lowest levels since 2008 and 2005, respectively.

• China's Infrastructure: Order intake from infrastructure construction contractors grew by 3% year-over-year in Q1 2024, the second lowest since 2016. A 2-4% yearly growth in orders is needed to maintain flat steel demand from infrastructure in the next 12-18 months.

• China's Consumer Durables: White goods output increased by 14% year-over-year in FY23 and 9% in both Q1 and Q2 2024. However, the recent 22% year-over-year decline in floor space completions could negatively impact future white goods demand.

Supply indicators

• Traditional supply: Supply from traditional sources (Australia, Brazil and South Africa) to China has grown at 1.4% annually since 2017. In 2024, it's expected to grow 3% year-over-year, as some supply disruptions seen in Q1 (like hurricanes in Australia and heavy rainfall in Brazil) have subsided.

• Non-traditional supply: Non-traditional iron ore imports into China are highly price sensitive. In FY23, these imports increased by 39% year-over-year as iron ore prices recovered. However, in July 2024, non-traditional imports dropped 7% month-over-month due to lower prices.

• China domestic supply: China's domestic iron ore production ranges from 180-270 million tonnes annually (62% Fe content). This supply, while outside the seaborne market, is also price-elastic, though less so than non-traditional supply.

Inventories

• Iron ore inventories at ports: Port inventories recently peaked at 157 million tonnes but have slightly decreased to around 150 million tonnes. Current inventory levels represent about 46 days of use, lower than previous cycle peaks of over 60 days.

• Iron ore inventory at steel mills: This is considered an underestimated leading indicator. Current inventory stands at 18 days of use, below the 13-year average of 27 days. This metric has shown the best correlation with iron ore prices, though the causality is not always clear.

• Steel inventories: Steel inventories are currently at a seasonally average level but are at their lowest point in five years, both at steel distributors and mills. This implies that iron ore inventory in the form of steel is also at a five-year low.

Putting it all together

China's economic data paints a bleak picture. Rather than implementing stimulus, Beijing appears to be doing the opposite. New Total Social Financing is down 15% year-on-year, while key indicators like property starts and infrastructure order growth have fallen to levels unseen since 2005 and 2015, respectively.

On the supply side, marginal producers in China and India are reducing output. But this is not enough to offset growth from major suppliers in Australia, Brazil and South Africa.

Despite indicators pointing to further challenges ahead, Citi believes iron ore prices have a floor due to the industry's cost curve. Citi's take on the cost curve not only includes free-on-board unit cash costs but also takes into account factors such as capex, transportation, royalties, freight etc. "This makes comparison among companies more meaningful," the analysts said.

"What this means is that iron ore is unlikely to fall below US$90 a tonne for any substantial length of time as long as the current cost structure holds for the industry," says Citi.

"The stocks are pricing in US$88 a tonne for the iron ore producers. Hence, we think it is a good time to revisit iron ore equities in our view."

Source: Citi Research

The multitude of headwinds flagged by Citi suggests that the path of least resistance for iron ore miners continues to be flat at best, if not lower. However, the cost curve indicates a potential buying opportunity if prices unexpectedly drop below US$90 a tonne. Despite the potential price floor, the current economic climate presents a volatile and challenging environment for investors considering iron ore stocks.