Big iron holds firm as price outlook nears Rio's fantasy land

[SYDNEY] Two months ago, Rio Tinto Group head Sam Walsh dismissed a forecast that iron ore prices may slump into the US$30s this year as "fantasy land." The price dipped this month under US$50 a dry metric ton on its way to a decade low of US$47.08 as Rio and BHP Billiton led the big producers in boosting output while demand growth slowed in China.

As forecasts get slashed, credit downgrades loom and China's steel output notched up its worst first quarter in two decades, the wisdom of the big miners is being tested.

Those producers have been caught off guard by how swiftly prices have tumbled, said Philip Kirchlechner, Perth-based director of Iron Ore Research, a former head of marketing at Fortescue Metals Group and an ex-Rio executive in China.

"To keep pushing tons I don't necessarily agree is such a good idea," he said. "I don't think they predicted the consequences of these expansions, and that the price fall in response to the expansions would be that dramatic."

They are pursuing a flawed strategy, according to Colin Barnett, premier of the Australian state that's home to their mines, who's also labeled the supply ramp up "dumb," while Australia's Treasurer Joe Hockey last week flagged he would discuss iron ore demand in talks with his Chinese counterpart.

In New York, Mr Hockey said there are many challenges ahead and pointed to the need for "shock-absorbers" to cope with a dramatic price fall. He said US$35 is a price level he's contemplating for the budget he hands down next month.

That's getting close to Rio and BHP's break-even prices, as estimated by UBS Group, while Citigroup sees prices averaging in the US$30s in the second half of 2015.

With prices trading around US$50, Chief Executive Officer Walsh conceded last week in London that Rio needed to do more to maintain the margin between the company and high-costs competitors, many of whom are being squeezed.

The price declines are "sort of self-inflicted," Australia & New Zealand Banking Group Chief Executive Officer Mike Smith said Wednesday at Bloomberg's Sydney office.

"The speed of the fall in iron ore has caught everyone by surprise, including the major producers," Chris Drew, a Sydney-based analyst with RBC Capital Markets, said by phone. With prices at about US$50, the big miners are unlikely "to be sinking a lot of new capital into their operations," he said.

BHP and Rio are acting in an "economically rational" way as they lower their production costs, according to Paul Phillips, a Melbourne-based analyst with Perennial Investment Partners, which owns BHP shares.

"BHP and Rio have been around for a very long time and been through many cycles, and they have the geology and the asset base that supports a low-cost position," he said. "In terms of their strategy, it makes sense."

If BHP doesn't ship the iron ore from Australia and leaves it in the ground, "someone else will step in and fill the gap," the Melbourne-based company said in an e-mail response to questions. The company decided about four years ago to stop investing in new projects, according to its statement.

In response to questions, Rio referred to comments from Andrew Harding last month, when the iron ore chief executive said cutting supply or scaling back expansions wouldn't be in shareholders' interests. Mr Walsh said in February that if the company reduced output, the forfeited supply would be made up by rivals.

Iron ore producers aren't moving quickly enough to limit supply as larger miners' balance sheets allow them to boost output, said Justin Smirk, a senior economist at Westpac Banking in Sydney. It's not just the major players resisting output cuts, but also the smaller guys, he said.

The industry will face a "breaking point" if output continues to climb and prices are driven below US$30 a ton, according to Bloomberg Intelligence. That's the level where many of the world's biggest producers would be at or below cost and forced to shut mines.

The big miners have no alternative but to pursue their strategy as boosting output is helping them cut costs per ton, and reversing course would hand market share to rivals, according to Goldman Sachs Group, which Thursday joined banks reducing price forecasts.

"Just as it was hard for them to get moving at the beginning of the China boom, it's hard for them to stop expanding, just like a stampede of elephants," Mr Kirchlechner said in an e-mail.

BLOOMBERG