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Iron Ore Decline Shows the Danger of Being Undiversified

23 Oct 2014 4:08 PM -

If you haven’t heard, Australia’s mining boom appears to be on the wane. While some commodities appear to be holding up, Australia’s largest mining export, iron ore, has spent the year on a downward slide with the spot price declining over 30%. Such declines bring sharply into focus the budgets of governments, the bottom lines of mining companies and the fortunes of undiversified investors.

Take Western Australia’s Key Budget Assumptions. The 2014-15 WA budget estimate was for an average iron ore spot price of US $122.70. The forward estimate for 2015-16 was for $120.10. For 2016-17 it was $117.60 and for 2017-18 it was an average spot price of $115.

As of writing the iron ore spot price had fallen below US $85. And the decline from over US $120 at the beginning of the year has already mothballed mining projects across the country.

In Tasmania, Shree Minerals started up their Nelson Bay mine in late 2013 and despite talk of 30 years of production and 150 jobs; mining activity had halted by mid-2014. There seemed to be ongoing conjecture regarding their costs; a Shree presentation suggested AUD $81 per tonne, but they stopped mining when the spot price slipped below US $100 per tonne.

Northern Territory iron ore miner, Western Desert Resources suffered an even more disastrous outcome with the administrators called in this month. Macquarie Bank clearly saw the writing on the wall for iron ore prices and wouldn’t extend Western Desert Resources’ $80 million dollar debt facility. WDR had been experiencing problems with its loading facilities.

There were some high profile shareholders and directors scalped in this debacle. Pokies billionaire Bruce Mathieson, former Coles Myer chairman Rick Allert, Billabong co-founder Scott Perrin and former Woolworths CEO Roger Corbett, among the notables. Another reminder that big names involved in a company aren’t actually a reliable indicator of success.

The most interesting story came from Macquarie’s research arm. Back in January, Macquarie Private Wealth analysts put an “outperform” recommendation on Western Desert Resources with a price target of $1.05. At the time it was trading at 71 cents and Macquarie analysts offered the following:

Our estimates suggest the company should generate sufficient free cash flow to repay the $80m debt facility with Macquarie Bank within 12 months.

And less than nine months later Macquarie pulled the pin on that debt facility. Though Macquarie Private Research wasn’t alone with their bad call. Foster Stockbroking and Commonwealth Bank Equities saw similar big things for Western Desert Resources.

Chalk up another big loss for share pickers and analysts!

The strange thing was the analysts’ blindness to what was potentially coming in the iron ore market – the thing they’re paid to know about! Not only had the higher iron ore prices been prompting junior miners like Western Desert Resources and Shree to jump in the game, the majors like BHP, Rio Tinto and Brazil’s Vale had forecast they would massively increase their production.

Take BHP’s production report for the year ended 30 June 2012. BHP’s iron ore production stood at just over 159 million tonnes per annum (mtpa). By the year ended 30 June 2014 it had swelled to 203 mtpa with the expectation of 245 mtpa in 2015 and potential growth to 270 mtpa in the future.

Similarly, Rio was producing 230 mtpa in 2012, but had expanded to 290 mtpa in 2014. Their end goal is 360 mtpa for 2015. There were similar production ramp-ups coming from Andrew Forest’s Fortescue – up to 150 mtpa and the start of Gina Rinehart’s privately held Roy Hill project at 55 mtpa. Looking at a cost comparison of ASX listed iron ore companies might give an indication as to why BHP and Rio were enthusiastically increasing production.

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$70 iron ore isn’t a great concern for Rio or BHP with their economies of scale, but a massive supply deluge could wipe out the majority of their listed competition. Not that any of this was given coverage in the establishment media over the past few years – nor from investment analysts who continued to have optimistic buy ratings on smaller iron ore miners.

This isn’t meant to be research on mining companies or the sector as a whole, but it is meant to be an indicator of how hard it is for an investor to successfully invest in individual companies or sectors. There are an immeasurable number of moving parts and variables that go into tracking the fortunes of one share.

Try being appropriately informed and abreast of the risks on 5-10 shares!

Especially when the information peddled by the media and investment analysts (the information many rely on) appears woefully ignorant until it’s too late. You might notice the media has now discovered the iron ore price has gone down and the reasons why. Subsequently, there are now wall to wall stories with experts and pundits telling us what we should expect next.

The same experts and pundits who’d previously told us to expect something completely different. Take Sydney Morning Herald economics editor, Ross Gittins, and his quotes from 2009 and 2012 that encapsulate the "she'll be right" message he's delivered his readers on mining over the past few years:

2009: That's the point that's slowly dawning: the resources boom is coming back and has decades to run. It will involve further huge expansion of our mining industry and huge growth in the volume of our mineral and energy exports, either at prices roughly the same as they are now or, quite possibly, higher.

2012: For a start, it's a bit soon  to be kissing the boom goodbye. Spending on the building of new mines and liquefied gas plants is expected to grow  strongly for another year before it starts to fall back. Even then, it will stay way above what we normally see for several more years.

Yet last month Gittins levelled with his audience, questioning the value of the boom and timing his backflip perfectly as iron ore looked to fall below $90.

So the chances of your mine being completed in time to enjoy the super-high prices aren't great - the more so because it's essentially a self-defeating process: the more firms join the race and the harder they try to be among the first to complete, the sooner supply catches up with demand and prices start falling.

Just another reminder to ignore the forecasts of journalists and media pundits. And if iron ore makes a recovery what commentary should we expect from Gittins then?

As for the iron ore companies listed above (excluding BHP and Rio Tinto) their share prices have all declined a minimum of 30% this calendar year. Rio Tinto is down 10% and BHP a more modest 5.5%.

Meanwhile, the ASX All Ordinaries is up nearly 5%. Listed property is pushing over 15%. Fixed interest is up just under 5% and international shares have returned under 0.5%.

Iron ore is an interesting sector, but if even “the experts” can’t get it right why should anyone else invest their time when a diversified portfolio combining the above asset classes has provided reliable returns over long time frames?

This represents general information only. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your personal investment objectives, financial situation and individual needs.

It’s never too early to invest in your future