In last week’s article, I noted that BHP (ASX: BHP) and Fortescue (ASX: FMG) have recently approved construction of new iron ore mines (South Flank and Eliwana, respectively) while Rio Tinto (ASX: RIO) is also likely to approve its proposed Koodaideri mine in the near future.
What is interesting is that all three mines are set to be replacement tonnes rather than expansion tonnes, consistent with current management’s mantra of “value over volume”.
To say this mantra is different from a decade back is an understatement.
Back then, all three big iron ore miners were intent on expansion, and you can see in Table 1 how much they have increased their iron ore production in recent years:
<<<Insert Table 1: Iron ore production – 2011 v 2018E>>>
|Company||2011 (MT)||2018E (MT)||Change (%)|
|Note: production figures are on a 100% basis|
Unsurprisingly, while total demand for iron ore has increased over the past seven years, these expansions have helped push down the iron ore price. Over US$160 per tonne in 2011, the iron ore price has plummeted to around US$67 today.
Volume over value?
Because mining is highly capital intensive and has significant fixed costs, economists suggest that it is “rational” for low-cost miners to expand their supply willy-nilly and try to take out higher-cost competitors.
I couldn’t disagree more.
By definition, commodities are interchangeable with other commodities of the same type.
In practice, though, the quality of the iron ore (or whatever commodity we’re discussing) differs from mine to mine. Whether it’s due to differing grades, different geology, different mine lives, the varying cost of labour, proximity to road or rail transport, ports and energy sources and so on, the cost of extracting the stuff from the ground and getting it to the consumer will vary from mine to mine.
All things equal, the lower your mine on the cost curve, the better.
In my view, a miner’s goal should be to maximise the discounted cash flows from its reserves over the life of its mines, not to irrationally expand production to gain market share by pushing down the price of the commodity in question to destroy higher cost competitors
So if you have the good fortune to own some of the highest quality, lowest cost and longest life iron ore mines on Earth – like Australia’s big three and Brazilian competitor Vale (BVMF: VALE 3) do – shouldn’t you instead use your competitive advantages to “manage” the iron ore price (legally, of course) to maximise your profits?
Particularly if you’ve already spent the billions necessary on infrastructure such as processing facilities, rail and ports?
Unlike most commodity markets, Australia’s big three and Vale are to a great extent price-makers rather than price-takers in the iron ore market.
Delicate but doable
Managing the iron ore price is a delicate task, of course: if prices are managed too high, then there’s a risk that new competitors will be attracted to the market.
Yet I think it would require much higher prices than currently – to hazard a guess, US$100 per tonne at a bare minimum, but probably materially higher than that – for this to be a risk.
This is because the big three Australian miners’ existing infrastructure presents a large barrier to new entrants.
To illustrate, Gina Rinehart’s Roy Hill mine, which produces “only” 55MT per year, cost more than US$7bn to construct, as Rinehart and her partners not only had to build the mine but also the railway and port facilities. As such, the project was approved when iron ore prices were above US$100 per tonne.
Existing infrastructure also gives the big three the ability to quickly and relatively cheaply add production should they mismanage the iron ore price too high and new competitors make noises about entering the market.
For example, BHP’s South Flank mine is slated to produce 80MT per year at a cost of US2.9bn, while Fortescue’s Eliwana mine is slated to produce 30MT per year at a cost of US$1.3bn. South Flank should be producing iron ore in 2021 and Eliwana in 2020.
Moreover, because iron ore mining is a scale game, it is unlikely that new entrants will be as low cost as Australia’s big three and Vale, given them even more flexibility to manage the iron ore price to maximise profits over the lives of their mines.
Do a Glasenberg
So while I am not a mining executive, this to me seems the proper way to run an iron-ore, or in fact, any miner.
This is why Glencore (LSE: GLEN) CEO Ivan Glasenberg – no fool – has repeatedly pointed out that oversupply rather than falling demand was the cause of the recent mining bust.
As such, whether it is iron ore, zinc or any other commodity, Glasenberg has suggested that if it doesn’t make sense to extract reserves, then the only proper response is to keep them in the ground until it does. This applies both to existing mines and proposed new mines.
To that end, he has regularly criticised BHP and Rio for their irrational (in my view) iron ore expansion plans in recent years.
It’s good to see Australia’s big three iron ore miners have finally decided to take his advice.