Iron ore miners should leave the market if they can't compete

Iron ore prices are plummeting, federal budget tax receipts are shrinking and Fortescue Metals Group chairman, Andrew “Twiggy” Forrest, reckons he knows who is to blame: BHP Billiton and Rio Tinto.

Forrest says these competitors drove down prices by flooding the market with product and has pushed for a federal parliamentary inquiry into their actions – a prospect Prime Minister Tony Abbott is said to be considering.

Forrest told ABC RN Breakfast last week that

When the chief executives of two of the most important companies to Australia both talk the market down, both say they’re going to oversupply the market there’ll be a lot of collateral damage to the Australian economy, employees by the tens of thousands, companies, and we no longer have a free market.

On Tuesday, BHP Billiton CEO Andrew Mackenzie responded by saying his firm has been a “very responsible fair producer” that had already partially slowed production, adding that:

… it’s a normal free market; if you allow it to remain free, it will allow the customer to enjoy the lowest cost of supply and therefore the most sustainable price and that stimulates demand and it’s good for the world economy… our prime customers in north Asia will be extremely disappointed that they paid high prices for iron ore to stimulate new production and then they expected of course that the price would come back to normal.

Mackenzie has a point. It seems sensible for high cost producers to either reduce their costs or leave the market if they cannot compete.

Playing a long game

It would appear that both Rio and BHP Billiton are making production decisions that are consistent with very long term, low cost operations. The astronomical prices of the last 10 year mining boom were a pleasant aberration, and many see the current lower prices as a price correction.

Commodity projects involve numerous checks for feasibility prior to construction, during construction and once the project starts producing.

Some projects, like the BHP Billiton Jimblebar Mine expansion project (completed in 2014) have contributed to BHP’s increasing output. Yet there has also been a raft of improvements to BHP’s supply chain over the years as the company works to increase efficiency. Each of these decisions are carefully weighed against current iron ore prices and expected future iron ore prices. Each decision step is inherently uncertain and projects can, and do, fail from time to time.

Huge companies like BHP Billiton and Rio exist because of their ability to deal with shocks and their ability to plan for the long term.

These companies have planning horizons of 50 years or longer for many of their projects. A serious error in the supply chain or in the assessment of the quality of the resources at an early stage can lead to disaster once production starts. These companies have extensive quality control systems in place to minimise the chance of these errors occurring.

Rio Tinto established a presence in Western Australian iron ore with the Mount Tom Price mine in 1966 and the Channar mine in 1990.

Similarly, BHP Billiton established Mount Whaleback in 1968. Its Jimblebar project was recently expanded, resulting in increased production as noted in its 2014 annual report, yet this project was initially established 25 years previously. These projects are not driven by short term price movements. The investments are huge and the risks substantial.

Relative newcomers

Many of the smaller Australian producers grew rapidly to deal with the increasing world demand and dramatic increases in prices that took place in the mid-2000s.

For example, Fortescue Metals Group was formed in 2003. Its Cloud Break Mine construction began in 2006, with first production shipped in 2008. Output was further increased with the development of the Solomon Hub, completed in 2014.

Fortescue says it is currently the fourth-largest iron ore producer in the world. There are a raft of other iron ore producers that have been created over the last 10 to 15 years, including Atlas Iron, which was listed in 2004. These miners have not seen the long periods of low-to-decreasing prices that have characterised the last 25 years.

Iron ore prices have changed rapidly over the last 10 years and this has wreaked havoc with development decisions. In 2004, the iron ore price in US dollars per dry metric tonne was around $USD16 per tonne.

This price would have supported a very different project to that which might be considered in 2006, when the price was $USD33 per tonne. And again, decisions might be different in 2010, when prices exceeded $USD100 per tonne.

Many of the large BHP and Rio projects currently in play were developed during periods when prices were around $USD13 per tonne. These companies have long memories and very restrained development decision making processes.

In a free market, they should not be punished for planning ahead or expected to operate at less-than-optimum efficiency just because their competitors cannot keep up.

Richard Heaney receives funding from the ARC. BHP Billiton, Rio Tinto and Fortescue Metals Group have made donations to Richard Heaney's employer, the University of Western Australia.