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Iron Ore: How It Impacts China, Brazil and Australia
Jul 9, 2015 17:45CST
Iron ore prices have tumbled by 58% over the past 12 months, far outpacing declines in other industrial metals.

By   09 Jul 2015  Last updated at  00:53:14 GMT

(CME Group) : Iron ore prices have tumbled by 58% over the past 12 months, far outpacing declines in other industrial metals. Copper prices, for instance, are down by only about 10% the past year (Figure 1), while aluminum and lead prices are down by just single digits in percentage terms. Nickel and tin have fallen by around 35%. Interestingly, prices for steel, which is primarily made from iron, have fallen far less, shedding about 30% in value (Figure 2).

Figure 1

Figure 2

Iron ore has a low correlation to other metals, including copper and hot rolled steel (Figures 3 and 4), making it a potentially interesting portfolio diversifier for those who have exposure to other metals.

Figure 3

Figure 4

Iron Ore Has Low Correlation with Copper and Steel

Although iron ore and copper are both used as industrial metals, they have very different supply and demand dynamics. First, the geographic locations of iron ore and copper deposits vary greatly. China is the world’s largest miner of iron ore, producing 47% of the world’s total in 2014, followed by Australia (21%) and Brazil (10%). Copper mining is more heavily concentrated in Chile, which produced 31% of the world’s supply in 2014, followed by China (9%), and Peru and U.S. (7% each). Since copper and iron, which is 500 times as abundant as copper, are mostly produced from different regions and mines, fluctuations in supply are not highly correlated. World mining data from the US Geological Survey show that between 1994 and 2014 the correlation of year-on-year changes in copper and iron ore production was -0.36. This goes a long way towards explaining why copper and iron price patterns are dissimilar.

The demand side of the equation for iron ore and copper is probably more correlated, given that both metals are heavily used in building materials and industrial products, including consumer goods. This should make them similarly sensitivity to changes to the global economy. That said, copper and iron are rarely substitutable and their demand base, geographically, is different as well. Although China is the world’s largest producer of iron ore (47% in 2014), it used over 70% of the world’s total iron ore supply. By comparison, , Chinese consumption of copper in 2013 amounted to 43% of the world’s total –still a very large share but much less than its appetite for iron.

Iron ore’s comparatively low correlation with steel can also be explained by the supply side. China consumes so much iron ore largely because it uses very little scrap in its steel production (which totaled 49% of the world’s total in 2014). This contrasts sharply with the United States, where 60% of the steel is fabricated from scrap. In developed countries like the United States, there is a large and steady supply of scrap steel from used cars, demolished buildings, etc. that can be used to create new products. Such large quantities of scrap are less readily available in rapidly developing countries like China, whose steel producers have to rely on iron ore and the other raw components of steel, such as carbon, nickel and chromium. The fact that coal prices haven’t fallen as much as iron ore (Figure 5) partly explains why steel prices haven’t dropped to the same extent, and why they remain fairly uncorrelated to iron ore.

Figure 5

When China Sneezes, Iron Ore Catches Cold

The recent decline in metals prices appears to be largely related to the slowing pace of growth in China, the world’s largest consumer of metals. There are several reasons for China’s deceleration, including:

  1. China’s currency, the Renminbi (RMB), remains closely tied to the U.S. Dollar and has followed the greenback higher against nearly every other currency in the world, making Chinese exports less competitive.

  2. China’s private sector remains fairly heavily indebted, with a higher debt burden than other emerging market countries (Figure 6). This may be contributing to a slowdown in Chinese construction activity.

  3. China’s leader, Xi Jinping, is cracking down on corruption, which might slow the pace of approvals for construction projects.

Figure 6

The three factors stated above may also be contributing to a slowdown in Chinese demand for iron ore, which may be facing additional pressures from a buildup of inventories in China.

To be clear, we don’t anticipate anything like a recession in China.  The People’s Bank of China (PBOC) has been easing policy by reducing its reserve requirement ratio for banks and cutting interest rates.  These moves should offset some of the impact from a strong currency, high private sector debt and the bureaucratic paralysis that results from the crackdown on corruption. To the extent that PBOC is able to stimulate investment and demand through easier monetary policy, it could prove to be supportive of iron ore as well as the currencies of the world’s key exporters of iron ore. Therefore, we would expect iron ore prices to respond positively to additional PBOC monetary easing.

Australia and Brazil

The collapse of iron ore prices is reverberating around the world.  Australia, the world’s largest iron ore exporter, could see as much as 2.2% shaved off its GDP growth as a first order consequence.  Brazil, the second largest exporter, is likely to see a 0.7% reduction in GDP as a first order consequence. The actual impact on GDP, however, could differ significantly (and could probably be less) than the first order consequence might suggest.  The recent depreciation of the Australian and Brazilian currencies will boost exports and protect their domestic industries from imports.  In the case of Australia, easier monetary policy will also mitigate the negative impact of lower iron ore prices. Brazil won’t be as fortunate: Its central bank has been tightening policy, and the government has been raising taxes and cutting spending, which in the short term will exacerbate the negative impacts of lower prices for commodities, including iron ore, on the economy.

As such, the undertow from the price collapse may have contributed to the weakening of the Australian dollar (AUD) and Brazilian real (BRL) (Figures 7 and 8).

Figure 7

Figure 8

Those seeking to evaluate exposures in AUD and BRL currencies might also look to the price of iron ore as a potential driver of returns. 

China’s slowing economy has had a disproportionate impact on the price of iron ore owing to its heavy consumption of the metal.  In the near term, the price of iron ore will likely remain an important indicator of the health of China’s construction and export-driven economy.  Moreover, it might continue to exert some influence on the AUD and BRL as well as monetary policies in Australia and Brazil. 

Courtesy : www.cmegroup.com


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