Why VALE, RIO, and BHP aren’t taking the lead in production cuts
Can an award-winning movie explain falling commodity prices? (Part 6 of 9)
Oversupply
Similar to the seaborne met coal (KOL) market, the iron ore market is also oversupplied. China (FXI) grew rapidly from 2011 to 2012. The growth increased demand.
In contrast, some mining projects by Vale S.A. (VALE), Rio Tinto (RIO), and BHP Billiton (BHP) were in the development phase. This created a supply deficit. Iron ore prices reached $139 per ton in 1Q12. Eventually, these mines came online. This boosted supply and drove prices down. Meanwhile, Chinese producers also increased their capacities.
Dwindling growth
New capacities came online. They were built in anticipation of growing demand from China. However, China slowed down. As a result, demand didn’t increase as fast as expected. Tighter credit to Chinese steel mills and a slump in the Chinese construction sector also contributed to dwindling demand for iron ore. As a result, prices started falling.
Prices continue to fall. Currently, iron ore is trading at $63.80 per ton. This is down 47% since the start of the year.
The result
So far, no major production cuts have been announced. VALE, RIO, and BHP are the iron ore producers with the lowest costs. In contrast, most of the marginal producers are based in China. They’re operating either as captive arms of steel producers or with government protection.
As a result of lower iron ore prices, production won’t be viable for some of these producers. This will correct the oversupply. Due to lower iron ore prices, new mining projects won’t be attractive.
It will benefit the three companies to keep the prices low in the short term. This will drive excess supply out of the market. Driving marginal players out will consolidate their position in the market.
However, the marginal players aren’t cutting back on production. If it takes longer to cut production, the prices could also decrease more. This is another example of the prisoner’s dilemma. We discuss the prisoner’s dilemma in the first part of this series.
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