Goldman proclaims the end of the Iron Age

Interesting developments in the iron ore market:

The iron ore price has just hit a new 5-year low and Goldman is out with a piece in which they conclude that the “end of the iron age” is near. Their analysis is a must read (read here at Zerohedge).

Goldman  basically states that we are shifting from an under supply phase in iron ore (2004-2014) to an oversupply phase which can be expected to last at least a decade. This comes as a result of the huge lags between investment and production – classic “Schweinezyklus“. To quote:

“On the supply side, the capital stock of the iron ore industry in Australia, Brazil and China increased by US$180 billion during the period 2003-12; this will fuel production growth for years to come (Exhibit 22). Now that the market has transitioned to an exploitation phase we expect new approvals for capital-intensive projects to become increasingly rare, largely because the economics of greenfield projects will be challenging in a oversupplied market. However, projects approved in the later stages of the investment phase will support production growth in the years ahead, and low-cost brownfield expansions at Tier 1 producers will remain attractive.”

So far, so good. With the difference that this time the demand picture might be unusually distorted, i.e. could prove to be much more elastic than historically observed due to the China factor. Again quote:

“On the demand side, lower prices for iron ore and steel are unlikely to boost demand in a material way. Instead, the day when steel production in China will peak gets ever closer. In the past decade, the Chinese economy added steel to its economy at a rate three times faster than the US did during the 20th century. On a per capita basis, the average household in China is accumulating steel at a rate equivalent to the purchase of a new car every 8 months (without disposing of its older cars). In other words, the volume of steel stock in China is racing towards the US level of 13 tonnes per person (Exhibit 21). If China is to converge towards the US level, steel consumption will eventually have to stabilize and steel recycling will play a larger role.”

Goldman’s analysts diplomatically choose the wording “…consumption will eventually have to stabilize…,” when in reality it is much more likely that Chinese demand will fall off the cliff once the absurd credit growth of the past decade subsides. I wonder whether any other outcome can be considered realistic given our experience of how investment booms end.

The piece is a must read, but if you time budget is constrained (not a good excuse) I have reproduced two charts that summarize the main point:

Goldman_iron_ore

Chinese steel-stock/capita is already at US levels. And yes, this is despite the fact that americans have several cars per household and despite the fact that there are still millions of hungry peasants in China that are eagerly waiting to move into cities.

The second chart depicts investments in iron-ore capacity per country. Note, how investment has really taken-off after the financial crisis, i.e. after we have already had books touting the commodity (around August 2008 oil hit USD 150/barrel) supercycle for half a decade. I can only speculate about why this is the case – long lead time for mine investments play a role for sure – but I think it also has to do with the fact that China’s investment binge really got out of control as a result of their huge stimulus program during the financial crisis.

Conclusion

A lot of China-derived growth stories (Australia, Indonesia, Brazil, African countries) will unravel and send ripples through the world economy in the next few years. Banks lending to these companies will be hit hard as it is safe to assume that they are overexposed (similar to the big German ship finance banks before 2008). On the other hand I can see how this type of deflation could be a stimulus for European economies that are importers of raw-materials thereby mitigating the effects of the sovereign debt crisis.

Disclosure: short AUD and CNY

 

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