The Commodity Investor: Weak Iron Ore Market is a Buying Opportunity

Columnist Amine Bouchentouf is a partner at Parador Capital LLC, an institutional advisory firm focused on commodities and emerging markets. He is the author of the bestselling Commodities For Dummies, published by Wiley. Amine is also the founder of Commodities Investors LLC, an advisory firm dedicated to providing insightful information on all things commodities. 

Iron ore prices have been on a downward spiral for most of the year. Spot prices have dropped from $180 per ton to $135 per ton. What’s more significant is that there don’t seem to be signs of an imminent rebound in iron ore prices any time soon. Prices for most of the world’s important industrial commodities have suffered significant losses over the last several weeks. These losses are primarily due to a slowdown that we’re seeing across key economic blocks in the global economy, and iron ore is at the center of global economic activity.

Most of the slowdown in the world’s economy can be traced back to the sovereign debt crisis currently afflicting the Eurozone economic block. The uncertainty in the Eurozone and the possibility of a second global financial crisis in less than four years has many investors worried. These worries are translating themselves in different ways around the world, including slower industrial activity in leading emerging economies such as India and China, two very important markets for the iron ore industry.

Chinese slowdown

China’s importance to the iron ore market cannot be underestimated. The country is the world’s biggest consumer of iron and has been a key price driver for years. When China sneezes, the iron ore markets definitely catch a cold. As a result of weak global growth, Chinese industrial activity has also slowed down and so have the country’s purchases of iron. Chinese demand for iron ore as measured by .IO62-CNI=SI, a Chinese benchmark for high-grade iron ore, is trading at six-month lows. This is happening because many of the country’s mills and traders are reluctant to purchase cargo because they’re currently sitting on large inventories that they’re finding difficult to sell in the domestic market.

The situation is so drastic in China that a 50,000 ton cargo from Eastern Europe has been waiting in a Chinese port for several weeks without any bids for the shipment. Just a year ago, the majority of iron shipments from Eastern Europe to China were sold even before the cargo left its home port. BHP Billiton (NYSE:BHP), a large supplier of iron ore to Chinese steel mills, held an auction this week where it sold its cargo for 7 percent less than it had sold a similar cargo earlier this month.

Chinese appetite for iron ore is simply not there, a fact that is having a major impact on iron prices globally and is putting a damper on many of the world’s major suppliers, including Eastern Europe, South America, and Southeast Asia. These circumstances are creating a vicious negative feedback cycle, and there’s no way of telling how far spot prices will go before they stabilize. What we do know is that the industry is cyclical and prices will eventually consolidate and stage a rebound.

Tight supply situation

The Commodity Investor’s view is that this weak market presents a unique buying opportunity. While we can’t call bottom yet, the prudent investor will keep monitoring the market for signs of consolidation and stabilization. When that occurs, prices will rise again, especially because the supply-side dynamics of the market are such that when demand does come back again, it will be very difficult to meet that demand. Labor costs, equipment and infrastructure constraints, and project cost inflation mean that it’s very tough for miners to increase production capacity.

Labor costs in Australia, one of the top producers globally, are having a serious impact on supply. Mitsui (TSE:8031) has entered into several joint ventures with both Rio Tinto (NYSE:RIO,LSE:RIO) and BHP Billiton for billion-dollar expansions in Australia’s Western Region, and all of these projects are behind schedule. The delays are primarily due to a shortage of skilled labor, which has increased labor costs enormously in the last couple of years; there are reports of crane operators at mining sites earning more than $200,000 a year, rivalling many banking salaries in the country’s capital. This labor shortage means that Australian companies are now finding it more cost effective to fly in labor from overseas to work in mining sites. This action is indicative of a very tight supply market, meaning that when demand does pick up again it will be very difficult for producers to ramp up production.

What’s an investor to do?

In anticipation of a price rebound, now, while spot prices are depressed, may be the right time to start building positions in iron ore companies. While it’s too early to call bottom on iron ore prices, it’s not too early to start monitoring selective stocks to eventually add to your portfolio.

I recommend the Brazilian industrial metal powerhouse Vale (NYSE:VALE), which is a leader in the production and distribution of iron ore globally. The stock is down 39 percent year-over-year and is currently trading at quasi-distressed levels with a PE ratio of 4.75, well below its peers. While the stock may experience further volatility, it looks very attractive at these levels and you have the opportunity of picking up a great company at a very good price.

For exposure to a smaller company with a potentially greater upside, take a look at Oceanic Iron Ore Corp. (TSXV:FEO,OTCQX:FEOVF). Oceanic is involved in the development of several promising deposits of iron ore in Northeastern Canada, in the Quebec region. The developments are located over 126,000 hectares. If the company is successful at commercializing these properties, the stock could do very well.

 Securities Disclosure: I Amine Bouchentouf, have no positions in the companies mentioned.