There’s an $8 Billion Iron Ore Quandary Ahead for Top Miners

(Bloomberg) -- The world's biggest iron ore miners are warning that prices are set to decline -- just as they need to begin spending as much as $8 billion developing new mines to keep their best cash machines ticking over.

Over the next five-to-10 years, the miners need new production to replace almost 170 million tons of capacity that'll be lost as exhausted pits are closed and grades decline at aging operations, according to Global Mining Research Ltd. Even with forecasts that demand for seaborne supply will peak in 2018 and prices may drop below $40 a ton that year, new iron ore projects are seen offering better returns than some alternative investments.

“Economically, it still makes a lot of sense to invest that level of capex, given the returns that these mines are likely to generate,” said Michelle Lopez, a Sydney-based investment manager at Aberdeen Asset Management Ltd., which holds BHP Billiton Ltd. and Rio Tinto Group shares and globally manages $403 billion. Yet, the decisions will be difficult and “for the first time they are actually up against real capital constraints, they haven't had that in the past couple of years,” she said.

The collapse in commodity prices in the past five years will see total global capital spending by mining companies drop about 60 percent to a forecast $57 billion next year, from $145 billion at the peak in 2012, according to Goldman Sachs Group Inc. estimates. Fortescue Metals Group Ltd., the No. 4 iron ore exporter, plans to make a decision within six months on a potential $1.5 billion investment to replace output, Chief Executive Officer Nev Power said last week.

Rio Tinto, which in August approved its $338 million Silvergrass mine, needs to develop a 50-million-ton mine about every five years to hold production steady, JPMorgan Chase & Co. said in an August note. Miners in Western Australia's iron-rich Pilbara region need prices between $36 a ton and $51 a ton to justify replacement expansions, which could total $8.2 billion, the bank estimates.

Prices in the $50 a ton to $60 a ton range will provide sufficient incentive for investments in expansions, according to global consulting firm EY. If prices collapse, then mine projects “may be shelved as the majors find better uses of their limited capital across the rest of the minerals portfolio,” according to Paul Mitchell, EY's global mining and metals advisory leader. “It is obvious that these replacement mines can never be considered to be ‘guaranteed' in an uncertain world.” Benchmark iron ore has averaged $54.70 in 2016, according to Metal Bulletin Ltd. data.

Iron ore's rebound in 2016 from three straight annual declines isn't sustainable and the market may need as long as a decade to rebalance, Rio's CEO Jean-Sebastien Jacques was cited by 21st Century Business Herald as saying last month in Beijing. He echoed similar comments by BHP CEO Andrew Mackenzie. About 30 percent of Melbourne-based BHP's current iron ore output in Australia will need to be replaced as the 80 million ton Yandi mine ceases production in about fiscal 2023, according to Macquarie Group Ltd.

BHP rose 0.4 percent to A$22.66 in Sydney trading Thursday, as Fortescue advanced 0.6 percent and Rio declined 0.5 percent.

‘Finite Capital'

Even if there's lower demand from China, iron ore production is likely to remain a high margin business, BHP's Mackenzie said in August. It would be “perfectly possible, in that environment, that we would still be able to justify an extension or a replacement,” he told investors on an earnings call.

Rio and BHP both declined to specify when they expect to take decisions on potential investments in replacement mines. Both producers have warned a proposed additional levy on their iron ore operations in Western Australia would put new projects in jeopardy.

The investment decisions will be made as China, the top commodities consumer, looks likely to favor other metals, including copper, as its economy shifts from growth rooted in steel-intensive infrastructure projects. Global refined copper demand may grow about 7 percent through 2020, more than double the rate of the world's iron ore imports over the same period, Barclays Plc analysts including Dane Davis wrote in a Nov. 1 note.

Iron ore developments will also need to compete against growth options in other commodities, according to researcher CRU Group. “There are internal fights for capital within the businesses, they are going to be allocating a finite amount of money across their whole portfolios,” Adrian Doyle, a Sydney-based senior consultant at CRU, said by phone.

To contact the reporter on this story: David Stringer in Melbourne at dstringer3@bloomberg.net. To contact the editors responsible for this story: Jason Rogers at jrogers73@bloomberg.net, Keith Gosman