On 5 March, the Steel Index benchmark iron ore price fell to $58.20 a tonne, the first time the index fell below $60 a tonne since 2009. A 0.25 percent rate cut by the Chinese central bank a few days earlier only provided temporary respite from continuing price declines; iron prices halved in 2014.
Yet at the same time the major iron ore miners, Rio Tinto, BHP Billiton, Fortescue, Vale and Hancock plan to keep expanding output even as forecasts for iron supply in production or coming into production outweigh forecast demand by three to one.
So we have a scenario where the biggest players are cutting costs, mothballing marginal price mines and squeezing out their smaller competitors who do not have the balance sheets and financing to survive a sustained price fall over the next few years. They hope pushing the smaller firms out of business will contribute to price recovery.
The capital markets already reflect this. Equity prices for junior Australian iron producers have fallen to the level where some firms, BC Iron, Mount Gibson Iron and Atlas Iron, have been removed from the S&P/ASX 200 index, their share prices falling on average 81 percent with market values below cash on hand.
At the same time debt financing is unavailable to even some of the biggest producers, such as Fortescue, which switched its $2.5 billion loan refinancing to the high yield bond market, only to pull that deal too, due to the high cost. The refinancing was designed to buy some breathing space for the miner, which has the thinnest margins of the big players.
A shallow view would suggest that this is the perfect time for distressed debt investors to take a punt on some miners. However, historically, debt financing has always been unavailable to exploration companies as there is no income for debt servicing. Junior producers are also primarily equity funded, so any private debt investor venturing into the area is going to have to negotiate primary debt or debt-like instruments with equity kickers. You cannot just go out and buy the stressed bonds in the secondary market, as you can with US shale gas for example.
Market barriers aside, mining is a highly technical area of business. Operationally you need engineers and geophysicists. Unless these skills pre-exist within your investment team or you can find and work with such a team then you will inevitably underestimate the complexity.
Add in the fact that mining is not exactly known for rigorous corporate governance, due to its inherently speculative nature. It’s bad enough when it is a major miner divesting a specific project, consider the juniors which generally lack strong financial or management systems and often have convoluted or disputed ownership structures.
Some have argued that this is a macroeconomic bet in many ways, a counter-cyclical play on commodity prices. The problem with this is that it assumes prices will recover or at least stabilize to a point where you can make a return and not end up owning uneconomic assets for years. How much visibility do we have on when and why commodity prices will recover? The outlook for recovery in iron ore and copper prices isn’t great – they are not the same as the oil price which is expected to rise again.
Without the technical skills to effect operational efficiencies or if there are simply none to be had, any mining investment is a bet on price increases. Then surely you are just trying to generate your returns from beta.
Are these the types of investments a private debt investor should be making? Is that what their LPs are paying them for?
The Australian mining industry is going through a painful period of forced cost cutting, financial restructuring and the eradication of marginal suppliers.
This will throw up opportunities for investment but it’s an area best left to those with an ace team of mining operational experts. Anyone else is better off giving money back to investors to leave them to make their own macro bets on commodity prices.
*Our regular Asia-Pacific columnist is based in Hong Kong and has his finger on the pulse of credit markets across the region.