Something has to give
The three major iron ore producers – Rio Tinto, Vale and BHP – produce the bulk of the world’s traded iron ore. And they have the vast bulk of the high-grade ore: 62%+ Fe.
There is quite a close correlation between Rio Tinto’s share price and the iron ore price (both in USD). This is because over 70% (H1 FY-18 results, released Aug-17) of its earnings come from iron ore. [Rio also mines hard coking coal, copper and diamonds, as well as producing aluminium.]
Source: IRESS, indexmundi.com, First Samuel
The graph above shows, over recent months, a deviation opening up from the normally quite correlated trend (red arrow).
There are two ways this deviation can resolve:
- Rio’s share price may come under some downward pressure, AND /OR
- the AUD may come under pressure – there is a degree of correlation between the AUD (as Australia’s economic performance is heavily influenced by commodity revenue and thus prices) and commodity prices, notably iron ore.
If the only factor to adjust was the AUD (which in reality is unlikely to be the case, and the AUD is driven by factors other than the iron ore price), it would need to fall to around 60 cents. This compares to around 75 cents today.
The other interesting dynamic that is currently occurring is in relation to lower grade ores. Low-grade ores (a greater quantity of which is required to produce a given amount of steel) have traditionally sold at a 5% to 10% discount to the high-grade benchmark price. However, recently this discount has widened, reportedly up to 40% for ores such as that mined by Fortescue.
This is being driven by the Chinese desire to reduce pollution; higher grade ores will cause less pollution for a given amount of steel produced. This is especially the case as they head into their winter, which is when pollution issues become more significant. The question now being debated is whether this will be a seasonal phenomenon (winter weather driven), or whether it will be structural in nature – as China’s focus on environment / pollution becomes more pronounced.
What does it mean for your investments?
The main direct exposure to iron ore in your equity allocation is BHP. For FY-17, 58% of BHP’s earnings came from iron ore. Any downturn in the iron ore price would result in lower earnings – in USD terms.
However, for BHP (along with RIO), a substantial component of the cost base is in AUD, and shareholders receive dividends in AUD terms. Thus, the Australian shareholder (in AUD terms), should be better off if the AUD fell.