Iron ore prices could fall to $US10 a tonne, and stay there

The price of iron ore is important, not only for investors but for the Australian economy.

Listening to the overnight market reports each morning on television, what stands out is the audible surprise in the voice of the reporter when describing another fall in the price of iron ore to new decade-lows.

The price of iron ore is important, not only because of its direct impact on the fortunes of investors who might have inherited BHP or RIO shares from their parents, but also for the fortunes of the Australian economy. It stands in testimony about successive governments’ ineptitude in planning for the long-term prosperity of Australia.

Commencing in early 2010, and ever since, I have warned investors that the iron ore price boom was a Potemkin Village (those fake villages the Russians would build to impress visiting nobility). I’ve said for a long time now that avoiding shares in iron ore producers was a given. This was despite the rather implausible arguments from some of my contemporaries that a floor in the price of the commodity would exist at the average production cost. What nonsense. Since time began commodity prices have traded below production costs at various times and marginal producers have gone broke.

I recall appearing on the ABC’s Inside Business program: following Fortescue CEO Nev Power’s observation that their long-term forecast for iron ore was $US100 a tonne, I observed that one should not ask a barber whether one requires a haircut!

With the iron ore price now close to $US50/tonne, many experts are forecasting prices that coalesce around the current price. That’s just typical! Humans are notoriously under-equipped to forecast turning points and markets tend to fall and rise to extremes previously unexpected. Westpac, for example, is forecasting iron ore to hit a low of $US47/tonne this year before recovering to $US69/tonne, on average, in 2016. Good luck with that.

If you want to be an accurate forecaster, forecast often!

If only forecasting so precisely was possible.

Commodity prices are related to cycles of prosperity and decline or stagnation. Quite simply during times of prosperity, for example when China was recently building its own Potemkin Villages in unprecedented quantities, the competition for productive inputs, such as iron ore, drove higher prices.

The resultant commodity boom was unprecedented. The iron ore price rose from $US20/tonne in 2004 to $US187/tonne in 2011, a historic high.

Of course, the rate of industrial urbanisation in China triggered the imagination of analysts who yet again suggested ‘‘this time is different’’, claiming that the boom would last for 100 years and was justified by the industrialisation and urbanisation of China, followed by India and then even Africa.

Unsurprisingly, supply intentions increased and it wasn’t long before brokers were recommending iron ore producers, based on increased production expectations multiplied by the new higher prices.

Of course, nobody had thought to aggregate the individual company production forecasts and what emerged was a picture of supply many times greater than the entire iron-rich Pilbara region produced annually.

However, lead times in the project development and production of iron ore are long, so the reconciliation of demand with supply can be pushed out far enough to be irrelevant. But time catches up quickly and only those who believed it was better to be six months early than six minutes late sidestepped the collapse in prices currently being experienced.

With that little bit of history safely tucked away, the question now is: how low can iron ore prices go?

Step one is to ignore the forecasts, a sample of which was provided above. For many decades prior to 2004, the price of iron ore traded between $US10/tonne and $US20/tonne. At those levels BHP and Rio did not go broke. But they didn’t make a great deal of money, in today’s dollars, either.

It would be a mistake to think prices couldn’t go there again.

The game now being played is to drive the price of iron ore lower, which in turn sends higher cost producers to the wall.

The last man standing wins. Even if the price of iron ore is $US10/tonne. Don’t be surprised if it gets there.

Roger Montgomery is founder and CIO of the Montgomery Fund.