An analyst shares his views...
DR. GEORDIE MARK is a research analyst with Haywood Securities. He focuses on uranium companies involved in exploration, development and production. He joined Haywood from the junior exploration sector, where he was vice president of exploration for Cash Minerals, which concentrated on uranium and iron oxide-copper-gold targets across Canada. Prior to joining the exploration industry, Mark lectured in economic geology at Monash University, Australia, and served as an industry consultant.
In this interview with The Gold Report he gives his view on the iron and steel markets.
The Gold Report: What can you tell us about the long-term fundamentals in the iron ore business and, ultimately, the steel business?
Geordie Mark: The thesis there is one of global growth in steel demand resulting from continued industrialization from advancing economies, particularly China. At the moment, China produces somewhere near 45% of the world's steel.
On the back of that, India is continuing to grow its internal steel production at greater than world average rates. So, 37% of the world's population, which includes only China and India, has significant growth in its underlying steel consumption and demand.
If you take a step back, these countries are both in the juvenile stages of their steel use. They still have a long way to go in ramping up their countrywide infrastructure requirements. This trend is expected to continue for a number of years, if not decades.
TGR: Investors commonly think of China and India as the primary drivers behind steel demand. However, I have a November 2010 report from UBS, which estimates that steel consumption this year will rise by 4.5% in Europe, 4.5% in Russia and 5% in Brazil—a little bit more than India and China. The growth forecast gets even more bullish in 2012. Are Haywood's numbers similarly robust in countries outside of China and India?
Geordie Mark: I would have to agree. China is obviously the main source of growth due to its size. For example, China's steel consumption is roughly eight times that of the US. But we are seeing significant growth from other countries, too. There are significant growth projections coming out of Europe, Russia and Brazil. The World Steel Association estimates global growth this year at 5.9% and 6% for 2012.
TGR: All that competition for iron ore is driving up the cost. China's imports of iron ore in the first quarter rose almost 15% to about 177 million tons (Mt). Meanwhile, the average import price was $156.50/ton in the first quarter, about 60% higher than in the year-early period. What are some ways to play this remarkable growth?
Geordie Mark: To play the growth, investors could look to companies that are either entering into production or can enter production in this period of high prices, which we believe will be about five years. In the short term that could include companies entering into production this year in order to get near-term cash flow and strong margins. Investors could also find growth in development-stage companies that could go into production within the window of high prices
TGR: What's your prediction for prices a year out from now?
Geordie Mark: This year we are forecasting an average price of around $139.50/ton for 62% Fe iron ore FOB Brazil. Next year, we forecast about $124/ton.
TGR: Why are the prices going down?
Geordie Mark: We have taken a conservative approach to building our forward commodity price curve given known supply growth, as well as uncertainty surrounding seaborne transport rates.
Furthermore, concordantly, the commodity has witnessed elevated pricing volatility whereby about a year ago, the industry came off an annual benchmark approach where the biggest mining companies negotiated with steel producers on an annual basis to fix prices. The rotation of the mechanics of commodity pricing within this industry was a result of the underlying demand-driven environment, which now places the iron ore producers with a lot more say in negotiations.
World iron ore pricing rotated out of an annual benchmark into quarterly indexing and a greater reliance on the spot price markets. In the last first quarter and second quarter price negotiations, we have increases in prices for the biggest mining companies, but as stated earlier we will also see greater volatility in the spot market relating to seasonal events and any fundamental policy changes out of China and other growth steel producers. Since we do see greater potential for volatility in the market going forward, we're resting on the conservative side for pricing.
TGR: The value of companies with iron ore assets or projects increased by an average of 400% between October 2005 and October 2010, whereas the value of metallurgical coal companies increased 34% during that same time, according to the UBS report. Steel companies were up 12% during that period. Part of that value creation is because steel companies have gone upstream and bought iron ore juniors to control the cost of supply. Do you expect that trend to continue?
Geordie Mark: I would say the valuation metrics driving steel companies and companies with iron ore assets differ appreciably given that the steel companies work on operating margins and output growth, whereas companies with iron ore assets and projects have moved up because they're increasing the underlying resource base, lowering apparent risk by moving through development or entering production in a market with elevated commodity prices.
We do see vertical integration being a very significant component going forward for the steel producers. Steel producers want to hedge away from the Big Three. These companies want to be independent and integrate their cost management into locking up some of their iron ore at cost. Such integration enables steel companies to be more competitive when selling steel. We believe that there is likely to be continued vertical integration in the sector as steel producers lockup supply and protect the underlying cost base.
There is good vertical integration potential in the sector, particularly within areas that have existing infrastructure or reasonable assurance in terms of asset ownership. Canada is a very good home for such activity.
TGR: What can investors expect in the iron ore market in the near term?
Geordie Mark: Growth should continue to emanate out of China and India, and bolstered recovery is taking hold in Europe, particularly Eastern Europe, and North America.
Another feature to look at is the cost of seaborne freight. There have been continuous lows in the market for seaborne freight because of surplus capacity that should continue for a number of years. Demand growth and lower transportation rates provide fantastic opportunities for pricing protection to moderate operating margins for projects entering production or at the development stage.
TGR: Thanks for your time, Geordie.
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