Why iron ore isn’t bending to the market crash

If the latest brutal market tumble is driven by fears of a hard landing for the Chinese economy, someone forgot to tell the iron ore traders.

The price of the steel-making ingredient is hanging on to yesterday’s gains at over US$70 a tonne even as ASX investors lost more $50 billion in paper wealth.

China is the biggest user of iron ore and demand for the mineral is linked to economic growth. The fact that the price of the commodity is unmoved by the spike in risk aversion in share markets indicates that the stock sell-off is driven more by sentiment than fundamentals.

This doesn’t mean that the S&P/ASX 200 (Index:^AXJO) (ASX: XJO) is acting irrationally. We are in need of a cleanout.

But once the dust settles, I think our iron ore producers like BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited Fully Paid Ord. Shrs (ASX: RIO) will be well placed to race ahead again – if what’s happening in the commodity market can be used as a guide.

There are logical reasons why iron ore is on the front foot. JP Morgan believes supply isn’t keeping up with demand.

Global steel production continues to grow strongly with China producing near record levels of the metal at 946 million tonnes per annum (Mtpa) in August, while the output from the big iron ore producers has only grown modestly.

“In our view, strong iron ore prices reflect tight fundamentals, with our supply-demand model showing a small deficit, with the void filled by higher Chinese domestic supply,” said the broker.

“We expect this tightness to persist throughout the remainder of the year, with the seasonal slowdown in Chinese steel demand likely to be offset by lower domestic iron ore supply through the winter months.”

The pick-up in steel production sounds contradictory amid the global trade war between the US and China. Trade tariffs will slow economic growth and are one of the key reasons why the International Monetary Fund had downgraded its global growth forecast.

But China is likely to respond by stimulating its economy by ramping up infrastructure construction and JP Morgan is convinced that this will be more than enough to offset a full-blown trade war between the world’s two largest economies.

If tightness in the iron ore market persists, the biggest beneficiary will probably be sector laggard Fortescue Metals Group Limited (ASX: FMG).

The stock has underperformed significantly as it produces lower grade ore that is heavily discounted by Chinese buyers.

However, the price of the lower grade ore has jumped 20% from early July – twice that of the high-grade product sold by BHP and Rio Tinto – as buyers scramble to find enough ore to satisfy demand.

I am not sure if the price of the low-grade ore will continue to increase at a faster clip but I suspect the rebound may mean the large discount gap between the two grades may start to revert to the mean after blowing out since the start of the year.

Fortescue may finally be able to play catch-up to its larger and more attractive rivals.

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Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited and Rio Tinto Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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