Iron ore won’t balance the budget

WA Premier Colin Barnett is pretty unimpressed. The big miners, he claims, are to blame for creating a huge hole in that state’s budget. They’re mining too much, apparently.

Now, I’m the last person to rush to the defence of our large miners (or our state governments, for that matter), but it’s hard to accept Mr. Barnett’s claims at face value. A more cynical observer might suggest he’s ducking for cover after the state’s bureaucrats and government so badly botched its royalty forecasts from iron ore.

They’re surprised?

I don’t want to be the guy to say “I told you so” but, well, I am on the record (more than two years ago) warning about the end of the iron ore boom. In short, high school economics tell us that excess profits (say, when iron ore was $140 per tonne) – especially in a commodity product – will always attract more competition. More competition, in the case of iron ore, means a surge of new production coming on stream. Those who can mine the red dirt at a cost of $50, $60 or $70 per tonne know there’s plenty of money to be made. More supply leads to lower prices, which, over time, will more or less converge with the cost of production.

That phenomenon isn’t just an Australian one, by the way. The supply and demand of iron ore is one of the most truly international markets – with some adjustments for quality, iron is iron is iron.

BHP, Rio and others know well the dynamics of this market. They know that there are plenty of miners around the world who’ll happily take lower prices in exchange greater volume. So, while Mr. Barnett might be right – that the big miners are causing the price to fall with their massive production increases – he fails to acknowledge that the previous status quo just wasn’t (and isn’t) sustainable.

Supply and demand. Rinse and repeat

Very simply, someone was always going to provide the extra iron ore. And prices were always going to fall as a result. So BHP, Rio – and the WA government – had two choices: produce the same iron ore at lower prices or produce more iron ore at lower prices. You’ll note there’s no scenario with this global commodity that allows for the same or higher prices. And if BHP and Rio had refused to increase volumes, you can bet London to a brick the WA government’s revenues would have been even more significantly impacted.

If the problem sounds familiar, it’s exactly the challenge that confronts Mr. Barnett’s federal counterparts. I don’t envy them – there’s no-one in the world who can accurately predict commodity prices. But if a government is spending this highly-variable revenue stream as if it’s perfectly regular and reliable, then they’ve made their own beds. That’s doubly the case when there’s a boom that any reasonable observer knew would end at some point. If I get a bonus from my employer, I don’t adjust my spending as if I’ll get that same bonus every year – I treat is as a nice surprise and spend it accordingly.

For investors, it’s another reminder just how concentrated our economy – and stock market – really is. We may have grown up on the sheep’s back, but we’re now clearly riding in the back of a mining truck… and the ride is getting bumpy. And without wanting to sound like Chicken Little, remember that our big banks, BHP and Rio make up 42% of the ASX 200’s weight – that’s some concentration.

Foolish takeaway

It can be incredibly easy to simply extrapolate when it comes to investing. What went up yesterday will likely go up today, right? Sometimes that's the case, but not always - as investors in iron ore, gold and mining services companies have found out.

Like state budgets, if your investment case for the miners, banks (or any other company) are centred on past performance, and doesn't take future growth (and the challenges therein) into account, you're skating on some thin ice.

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Scott Phillips is a Motley Fool investment advisor. You can follow Scott on Twitter @TMFGilla. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).

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