Flaws in the iron ore market-flooding strategy

DOES flooding a market make sense? That’s a question which has kept Dryblower* awake recently as Rio Tinto and BHP Billiton expand iron ore production despite a falling price, and while most observers are unsure there are at least three people who think it’s a daft strategy.
Flaws in the iron ore market-flooding strategy Flaws in the iron ore market-flooding strategy Flaws in the iron ore market-flooding strategy Flaws in the iron ore market-flooding strategy Flaws in the iron ore market-flooding strategy

 

Tim Treadgold

The first person to speak out against flooding the iron ore market was the Premier of WA, Colin Barnett.

The second was Dryblower who doesn’t always agree with Barnett but reckons he’s got it right this time.

The third, and easily the most important person to voice an opinion so far, is Clarke Wilkins, director of metals and mining research at the investment bank, Citi.

Barnett’s views have been well aired, as have Dryblower’, so there is no point in repeating them, just to say that what’s happening is straight from a management hand-book titled “race to the bottom”

The big problem with a race to the bottom is that on the way down a lot of people and companies are damaged and there is no guarantee that the people who think they’re going to win actually come out on top.

Executives employed by Rio Tinto and BHP Billiton are confident that they will win the iron ore version of the race to the bottom but it remains to be seen whether the owners of the companies, the shareholders, are so confident that their money is being invested wisely.

Wilkins, a man with a well-deserved record for getting it right, is the first big-name resource analyst to question whether what’s happening (a) makes sense, (b) whether it will produce the desired outcome, and (c) whether in the case of Rio Tinto it’s actually part of a forced strategy.

Time will tell who’s right but given comments made earlier this year by Wilkins which correctly tipped the big fall in iron ore prices his latest research note deserves close attention.

Back in February, just before an annual iron ore and steel forecasting conference in Perth, it was Wilkins who tipped a bucket of cold water on the iron ore miners with the only error in his work being that his price projections arrived earlier than forecast.

The $US80 a tonne price for iron ore wasn’t due until 2016, according to the Wilkins who had expected a more orderly correction with the downward slide likely to be from $118/t in early 2014, to $90/t next year, and then down to $80 the year after.

At the time of those price tips Wilkins was largely ignored, which was enormously surprising because he published them just days before the conference – at which he was the opening speaker.

Roll forward to last week and the fresh warning shot from the Citi man who has this time gone beyond Rio Tinto management to alert shareholders about his views.

In a report which will reverberate well into next year Wilkins wondered whether flooding the iron ore market, and other possible changes ahead for Rio Tinto, was a result of being “forced into a strategy” – a point directly linked to the merger proposal from arch-rival Glencore.

The key comment from Wilkins lies in the seven snappy words that start his analysis: “Holding your breath longer than anyone else” – a remarkably apt assessment of market flooding because it is based on an assumption that the companies doing the flooding will eventually win what could become a war of attrition.

“Expanding low-cost iron ore production and hoping that competitors will go bust first appears to us to be a limited strategy that could see Rio Tinto equity holders losing out,” Wilkins wrote last Thursday.

Perhaps even more significantly, he added that the Glencore merger proposal might have put pressure on Rio Tinto management which was looking more closely at the company’s share price “rather than long-term shareholder value”

Whatever the cause of the market flooding there seems little doubt that a process has been started which could be have unexpected and ugly outcome for everyone exposed to iron ore.

Smaller companies will obviously suffer as the price is crushed by excess production. The WA Government’s royalty income will take a haircut despite the higher tonnage being shipped, and the flooding could prove to be just one dramatic result of the Glencore merger proposal.

There are other possible developments from what Wilkins referred to as a forced strategy, including Rio Tinto taking on more debt to buy back more of its own shares to boost the share price, or quitting the Alcan aluminium business, either by sale or spin-off.

Whether those future steps will be taken is uncertain. What is certain is that Rio Tinto and BHP Billiton have embarked on a flooding strategy that could prove to be just as costly to the shareholders of those companies as it is to small miners today.

*First published in sister publication MiningNews.net on Monday.

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