The deformations in the global economy arising from the central bank fueled credit deluge of the last two decades become more visible and foreboding by the day. One vector of special salience is the global iron ore market where prices have now punctured the $100 per ton mark to $94, and are down 50% from a peak of $200 in 2012.
The action here is not just another commodity cycle, but instead is a proxy for the global credit bubble, China department. During the course of its mad scramble to become the world’s export factory and then its greatest infrastructure construction site, China’s expansion of domestic credit broke every historical record and has ultimately landed in the zone of pure financial madness. To wit, during the 14 years since the turn of the century China’s total debt outstanding–including its vast, opaque, wild west shadow banking system—soared from $1 trillion to $25 trillion, and from 1X GDP to upwards of 3X.
But these “leverage ratios” are actually far more dangerous and unstable than the pure numbers suggest because the denominator—national income or GDP—-has been erected on an unsustainable frenzy of fixed asset investment. Accordingly, China’s so-called GDP of $9 trillion contains a huge component of one-time spending that will disappear in the years ahead, but which will leave behind enormous economic waste and monumental over-investment that will result in sub-economic returns and write-offs for years to come.
Nearly every year since 2008, in fact, fixed asset investment in public infrastructure, housing and domestic industry has amounted to nearly 50% of GDP. But that’s not just a case of extreme of growth enthusiasm, as the Wall Street bulls would have you believe. It’s actually indicative of an economy of 1.3 billion people who have gone made digging, building, borrowing and speculating.
Nowhere is this more evident than in China’s vastly overbuilt steel industry, where capacity has soared from about 100 million tons in 1995 to upwards of 1.2 billion tons today. Again, this 12X growth in less than two decades is not just red capitalism getting rambunctious; its actually an economically cancerous deformation that will eventually dislocate the entire global economy. Stated differently, the 1 billion ton growth of China’s steel industry since 1995 represents 2X the entire capacity of the global steel industry at the time; 7X the size of Japan’s then world champion steel industry; and 10X the then size of the US industry.
Already, the evidence of a thundering break-down of China’s steel industry is gathering momentum. Capacity utilization has fallen from 95% in 2001 to 75% last year, and will eventually plunge toward 60% and a half billion tones of excess capacity. Likewise, even the manipulated and massaged financial results from China big steel companies have begin to sharply deteriorate. Profits have dropped from $80-100 billion RMB annually to 20 billion in 2013, and are now in the red; and the reported aggregate leverage ratio of the industry has soared to in excess of 70%.
But these are just mild intimations of what is coming. The hidden truth of the matter is that China would be lucky to have even 500 billion of annual “sell-through” demand for steel to be used in production of cars, appliances, industrial machinery and for normal replacement cycles of long-lived capital assets like office towers, ships, shopping malls, highways, airports and rails. Stated differently, upwards of 50% of the 800 million tons of steel produced by China in 2013 likely went into one-time demand from the frenzy in infrastructure.
Indeed, the deformations are so extreme that on the margin China’s steel industry has been chasing its own tail like some stumbling, fevered dragon. Thus, demand for plate steel to build dry bulk carriers has soared, but the underlying demand for new capacity was, ironically, driven by bloated demand for the iron ore needed to make the steel to build China’s empty apartments and office towers and unused airports, highways and rails.
In short, when the credit and building frenzy stops, China will be drowning in excess steel capacity and will try to export its way out— flooding the world with cheap steel. A trade crisis will soon ensue, and we will shortly have the kind of globalized import quota system that was imposed on Japan in the early 1980s. Needless to say, the latter may stabilize steel prices at levels far below current quotes, but it will also mean a drastic cutback in global steel production and iron ore demand.
And that gets to the second half of the deformation arising from central bank fueled credit expansion and the drastic worldwide repression of interest rates and cost of capital. The 12X expansion of China’s steel industry was accompanied by an even more fantastic expansion of iron ore production, processing, transportation, port and ocean shipping capacity.
On the one hand, capacity could not grow at the breakneck speed of China’s initial ramp in steel production—so prices soared. And again, not just in the range of traditional cyclical amplitudes. In fact, prices rose from $20 per ton in the early 1990s to $200 per ton by 2012—meaning that vast windfall rents were earned on the difference between low cash costs on existing or recently constructed iron ore capacity and the soaring prices in spot and contract markets.
The reality of truly obscene current profits and the propaganda about endless growth in the miracle of red capitalism, combined with the cheap debt available in global capital markets, resulted in an explosion of iron ore mining capacity like the world has never before witnessed in any mineral industry. The attached story on the massive new capacity still coming on-stream in western Australia provides a dramatic picture of how far this got out of hand.
So the mother of all commodity bubble collapses is virtually baked into the cake. As one CEO quoted in the story makes clear, his cash cost of production is about $20 per ton and he will not hesitate to keep producing for positive variable profit. That means iron ore prices will also plunge far below the current $94 per ton quote.
In short, when the classical economists talked about “malinvestment” the pending disasters in the global steel and iron ore industries (and also mining equipment and other supplier industries) are what they had in mind. Except none of them could have imagined the fevered and irrational magnitudes of the deformations that have resulted from the actions of the mad money printers who now run the world’s central banks.
Iron ore shipments from Australia’s Port Hedland expanded to a record in May as mining companies boosted output, helping to push benchmark prices to the lowest level since 2012 and contributing to a rising global surplus.
Exports from the world’s largest bulk export terminal surged to 36.1 million metric tons from 34.8 million tons in April and 27.9 million tons in May 2013, data on the port authority’s website showed today. Shipments to China were a record 29.9 million tons in May compared with 28.9 million tons in April and 23.3 million tons a year earlier, the data showed.
Producers in the world’s largest shipper including BHP Billiton Ltd. and Fortescue Metals Group Ltd. (FMG) are expanding supplies, betting that increased volumes from low-cost mines will more than offset declining prices. The raw material capped a sixth monthly drop in May in the longest losing run on record. Iron ore could extend declines over the next year, according to Fortescue Chairman Andrew Forrest, and Australia & New Zealand Banking Group Ltd. cut its price forecasts today.
“Miners are lifting output,” said Justin Smirk, a senior economist at Westpac Banking Corp. in Sydney. “As long as iron ore remains at a price where miners can deliver it at a profit, it may be a shrinking profit, but if they’re still making money they’ll keep” producing, he said.
Iron ore with 62 percent content delivered to the port of Tianjin advanced 2.3 percent to $94.60 a dry ton today, according to The Steel Index Ltd. Prices have slumped 30 percent this year, reaching $91.80 on May 30, the lowest since Sept. 7, 2012. They could drop as low as $80 or rise as high at $140 over the next 12 months, Forrest said in Melbourne on May 30.
Global Glut
The global seaborne surplus will jump from 14 million tons last year to 72 million tons in 2014 and 175 million tons in 2015, Goldman Sachs Group Inc. said in a May 20 report. Worldwide supplies will expand 10 percent in 2014, outstripping the 3.7 percent rise in demand, Morgan Stanley predicts.
A further slide in the price would place competitors under pressure, Rio Tinto (RIO) Group Chief Executive Officer Sam Walsh said in an interview with Bloomberg Television yesterday, describing $80 as too low. Rio is the second-biggest producer and last year derived about 88 percent of earnings from the commodity.
“We are the lowest-cost producer in the world, with costs of $20 per ton compared to the price around $92 a ton; I think we’ll be OK,” the 64-year-old Australian said. “I don’t think we’re going to go down to $80 or else a lot of my friendly competitors are going to disappear.”
‘Socks Off’
In the first five months of the year, iron ore exports from Port Hedland totaled 161.3 million tons, 34 percent higher than the same period in 2013, according to Bloomberg calculations based on port data. Shipments to China surged 36 percent to 130.5 million tons in the January-to-May period.
“Our miners are exporting their socks off and thank God because it’s having an impact, a positive impact, on our economy,” Treasurer Joe Hockey told reporters in Canberra today after the release of government figures that showed the economy grew at the fastest pace in two years in the first quarter.
“Growth has been driven unquestionably by net exports,” said Hockey. “But what we found over this March quarter, it’s an extraordinary quarter in March when you don’t have cyclones, particularly in Western Australia affecting Port Hedland.”
While iron ore looks oversold and may rebound as much as 15 percent in the coming months, average prices may be less than previously forecast from this year through 2016, ANZ said in separate reports. Prices may average $110 a ton this year from a previous estimate of $120, and $106 in 2015 from $118, it said. Increased Australian output will hurt higher-cost Chinese supplies, establishing a new floor price at about $100, it said.
Strike Threat
Tugboat workers have approved work stoppages at Port Hedland, risking disruptions BHP estimates may cost suppliers A$100 million ($93 million) a day. BHP, Fortescue, Australia’s third-largest producer, and Atlas Iron Ltd. (AGO) all ship output from the Pilbara region through the facility in Western Australia, while Rio Tinto exports through Cape Lambert and Dampier.
The Australian Maritime Officers Union and the Maritime Union of Australia have approved strikes against Teekay Shipping (Australia) Pty in Port Hedland. A third union, the Australian Institute of Marine and Power Engineers is balloting members and expects results from its workers on June 10.
Iron ore stockpiles at ports in China, the world’s largest steelmaker, increased for an eighth month in May, reaching a record 106.86 million tons last week, according to Beijing Antaike Information Development Co.
Mine Expansions
Fortescue said April 16 it completed an expansion to nearly triple capacity to 155 million tons, while BHP in April raised its full-year output estimate 2.4 percent to 217 million tons after third quarter output surged. Rio said on April 15 that the expansion of its capacity to 360 million tons a year is on track for completion by the end of the first half of next year.
“We are confident with our projections that as we go forward the expansions that we’re making will be justified,” said Rio’s Walsh. “I think that $80 is too low, I suspect a level somewhere north of $100 is probably more realistic.”
