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Restocking Boosts Iron Ore Prices but Outlook Still Bearish

Last week, iron ore prices rose sharply, driven by restocking in China, the world's largest consumer of the bulk commodity. A rebound in iron ore prices would be welcomed by miners such as Rio Tinto (NYSE: RIO  ) , BHP Billiton (NYSE: BHP  ) , and Vale (NYSE: VALE  ) , which rely heavily on the commodity for their profits and cash flows. However, the outlook for iron ore still remains bearish as the seaborne market is expected to remain oversupplied for the next few years.

Iron ore prices recover
Iron ore prices dropped to $89 a ton in mid-June, which is almost a two-year low for the commodity. As I have noted in previous articles, the sharp decline in iron ore prices has been driven by concerns over a significant supply glut. After years of demand exceeding supply, the iron ore market is expected to go into a surplus as miners such as Rio, BHP Billiton, and Vale ramp up production. The supply glut is happening at a time when demand from China, the most important market for iron ore miners, is cooling down.

As iron ore prices fell to a near two-year low last month, steel mills in China began restocking. Some improved economic data from China also boosted prices. Spot prices of benchmark ore, with 62% iron content, rose to $96.5 a ton last week. Despite the sharp rebound, iron ore prices are still down sharply for the year. More importantly, the outlook for the commodity remains bearish as steel mills in China are now holding back as inventories at Chinese ports remain at record levels.

Bearish outlook remains
According to Reuters, record high stockpiles of iron ore at China's ports have curbed any urgency to buy spot cargoes among Chinese steel mills. As per data from SteelHome, iron ore stockpiles at China's port stood at 113.7 million tons last week, a record.

Reuters, citing a trader in Shanghai, noted that after boosting iron ore inventory to 28-30 days of use, some steel producers in China are now stepping back from the market.

As I have noted in previous articles, China's demand will cool down as it continues to rebalance its economy from investment and exports to consumption. Unfortunately for iron ore miners, the rebalancing is happening at a time when they are ramping up production.

Despite the sharp decline in prices this year, BHP Billiton is raising its iron production to an annual rate of 270 million tons. It must be noted though that the company has not given a timeline for achieving the production target. BHP's production for the fiscal year ended in June is expected to be 217 million tons. Rival Rio Tinto expects current full-year production to be 295 million tons.

The reason Rio and BHP are ramping up production despite the bearish outlook is because even if prices were to drop to $80 per ton, they would remain profitable. For mining giants, lower prices offer an opportunity to increase their market share as at current levels several high-cost mines in China and elsewhere will shut down. While this will benefit the companies and their shareholders in the long term, the near-term plans to boost shareholder distributions will certainly be affected.

Shareholder distributions under threat
Indeed, while lower iron ore prices do not threaten iron ore majors' profitability, they do threaten shareholder distributions, at least in the near-term. After iron ore prices surged last year, both BHP Billiton and Rio Tinto said that they would consider returning cash to shareholders through buybacks. However, an almost 30% drop in iron ore prices now means that miners' cash flows will be reduced even as they remain profitable. According to analysts at Macquarie and Credit Suisse, if iron ore prices remain at around $90 a ton, Rio and BHP are not likely to meet their debt targets. Consequently, analysts believe that the mining giants will not be in a position to buy back shares anytime soon.

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Varun Chandan

I have a Master in Finance degree from IE Business School in Madrid. I use the top-down approach when it comes to investing. I like to analyze macroeconomic factors and how they impact individual companies.

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