Uncertain Outlook Remains For Iron Ore Prices

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By Chris Shaw

Buyers elsewhere have agreed on contract pricing terms for iron ore with a 33% cut for iron ore fines and a 44% reduction in lump prices but Chinese steelmakers continue to stand firm on their view the price cuts agreed elsewhere for current year contracts are not enough given the balance in the market at present.

As National Australia Bank minerals and energy economist Ben Westmore notes, this stance comes at the same time as the Chinese Government’s stimulus package has triggered activity in the steel sector, with volume of production increasing from minus 12.5% as at October last year to growth of 14.4% in year-end terms as at the end of June.

As steel output has increased so too has Chinese demand for the raw materials used in steel production, namely coal and iron ore. Westmore points out Chinese imports of iron ore are up 46% for the year to June, an increase significant enough to see prices level out after a period of sharp falls from the highs around the middle of last year.

In Westmore’s view some of the demand has been centred on increasing stockpiles while prices are relatively low and this means Chinese buying could moderate to some extent in coming months, but with Chinese export markets expected to show signs of picking up by the end of the year this should mitigate the extent of any moderation in iron ore prices.

The fact negotiations are dragging means there is a chance the current benchmark contract system could break down and while the likes of BHP Billiton ((BHP)) have expressed their desire to see changes to the system, most iron ore buyers and other producers such as Vale of Brazil appear against such an outcome as it may create greater volatility in prices.

The risk, according to Westmore, is China ends up paying more by waiting as he notes current spot prices in China are above the 2009 benchmark, so a mutually beneficial agreement where the benchmark price is agreed but with bi-annual negotiations going forward remains a possible outcome.

The uncertainty over the iron ore pricing outcome is creating some earnings uncertainty for BHP given the importance of the Chinese market, as the Australian Bureau of Agricultural Economics estimates 53% of Australian iron ore exports go to China.

According to Deutsche Bank, the issue with respect to BHP’s earnings in the sector is the uncertainty of estimating pricing as while 30% is locked into non-benchmark pricing 47% of output has no price settlement at present. While the broker notes this also provides an opportunity as non-benchmark sales could be increased, so taking advantage of current spot prices, it also means there is significant risk if prices do come down in coming months.

For Bank of America Merrill Lynch this uncertainty is too great and it maintains a Neutral rating on the stock with a price target of $40.00. Deutsche Bank has a similar Hold recommendation but regards the stock as relatively expensive when compared to both Rio Tinto ((RIO)) and its own valuation.

Overall BHP Billiton is rated as Buy three times and Hold six times, with an average price target of $37.24. By way of comparison Rio Tinto scores seven Buys and one Neutral, with a couple of brokers currently prevented from offering a rating on the stock.

Shares in BHP today are weaker and as at 1.00pm the stock was down 36c at $37.07, while Rio Tinto was 24c higher at $58.24.

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