Speculative traders are betting aggressively that iron ore prices will continue to drop, placing the Australian government in a sticky situation ahead of its May budget.
The price of Australia’s largest export has dropped sharply in recent days, falling 3.5 per cent on Tuesday to $US66.25 a tonne and 30 per cent down from its mid-February high.
An investor looks at an electronic board displaying Shenzhen trading stock prices at a brokerage house in Beijing, Monday, Dec. 5, 2016. Trading began Monday on a new cross-border stock link between Hong Kong and the neighboring Chinese city of Shenzhen, widening access to China’s markets for global investors. (AP Photo/Andy Wong) Photo: ANDY WONG
“The iron ore market definitely isn’t as tight as it was a month ago,” says Daniel Morgan, commodity analyst at UBS. “Speculators are looking at the composition of the market and are taking an aggressive view that iron ore is going to drop.”
Stockpiles of 62 per cent ore have emerged at Chinese ports as steel mills switch back to low-grade, cheaper stock.
At the same time, the wet season in Western Australia and Brazil is drawing to a close, signalling that the supply of further high grade material is coming back into the market.
“The combination of all of those things has prompted the price to go into freefall,” says Mr Morgan. “But speculators can only take the price away from the fundamentals for so long, ultimately the supply-demand balance will dictate the price.”
The raw material for steelmaking entered a bear market this month as a wave of analysts, Australia’s government and even some miners said gains to 2014 highs were unsustainable.
While Australian and Brazilian mines are poised to push further high-grade supply into the market, low-grade content from the likes of India and West Africa are also placing downward pressure on spot prices.
“But the marginal cost of iron ore is about $US70-$US75 a tonne,” says Mr Morgan. “So if the price gets too far below that level, over the course of the next month, you should see the price tracking back towards that.”
Vigorous demand for high-grade iron ore has kept iron prices artificially elevated in recent months, setting the Australian government up for a healthy windfall ahead of its May budget.
However, three weeks out from the budget’s release and a plummeting iron ore price could skew outward looking forecasts.
Generally, Treasury will average the iron ore price out for the previous eight weeks and use that as a forecast.
“But the iron ore price certainly has been moving around a fair bit so it will be interesting to see what the price the government uses will be,” says Kerry Craig, global market strategist at JP Morgan.
“It’s likely they’ll have a healthier windfall from higher prices than this time last year, but the question is really whether that gets put towards paying down debt or spent in the economy.”
While a lift in commodity prices will give the government some further wiggle room, the potential loss of its AAA status is plaguing Treasury in the lead-up to the budget.
Standard & Poor’s has previously pointed to the government’s failure to enact its repeated promises to find new budget savings and increase revenue measure to reduce the deficit, as the catalyst for a potential downgrade.
Should Australia lose its AAA rating, there are concerns around what it might mean for funding costs.
“It’s hard to keep a AAA status for your financial sector when your government doesn’t have it,” says Mr Craig.
“So there might be some knock ons to the banking sector if they lose it, but materially, it would be better for the economy to spend any commodity windfall on infrastructure.”