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Why Should I Care if Coking Coal and Iron Ore Spot Prices Have Bottomed?
Foolish investors should want to know if spot coking coal and iron ore prices have bottomed. And the answer is... I don't know. But, there's a decent chance they have. The reason is pure economics, supply and demand. Global demand is weak and supply of both coking coal and iron ore is too high. This situation has played out because economists and pundits of all stripes predicted Chinese economic growth would rebound in the seconf half of 2012. Recall that everyone was watching Chinese inflation, waiting for it to cool down so that the Chinese economy could heat up.
The question at hand is vitally important to companies like Vale, (NYSE: VALE), BHP, (NYSE: BHP), Walter Energy, (NYSE: WLT) and Teck Resources, (NYSE: TCK). Iron ore accounts for close to 90% of Vale's earnings. Even though the current spot price of $115-$120 per metric tonne is sufficient for Vale to maintain solid profits, the market wants more. With a 6% yield, Vale is poised for a bounce when iron ore prices move back into the $120's / $130's.
BHP is a top 3 producer of iron ore and the single largest producer of coking coal in the world. The Company is just now recovering from an 18-month labor strike in its coking coal operations. As BHP supply comes back on line it is weighing on the spot price. Walter is the largest producer of premium hard low-to-mid vol coking coal in the U.S. Walter reported solid earnings last week and is of the opinion that coking coal prices are at bottom. Teck Resources is the 2nd largest producer of premium hard coking coal in the world and the largest in North America. Teck managemennt expects improvement in demand from China in the 4th quarter.
How Did We Get Here?
Steel mills, construction companies and commodity traders took long positions in various commodities only to learn that the economy did not pick up in July. And, the outlook for August looks no better. Although other factors are involved, the result is that a flood of commodities, including coking coal and iron ore, is hitting the market as long positions are unwound. Spot markets for coking coal and iron ore are illiquid even in the best of times. Today's highly illiquid markets have offered minimal pricing support. However, economics holds the answer to falling commodity prices through the concept of marginal cost.
What is the Marginal Cost of Coking Coal and Iron Ore?
I've read several analyses of what the estimated marginal cost is for coking coal and iron ore. The ranges are fairly tight, about $175-$185 per metric tonne for coking coal and $110-$120 for iron ore. Not surprisingly, spot prices for these commodities are in the middle of these estimated marginal cost ranges. Foolish investors should consider two important things. First, are analyst estimates of marginal cost accurate, and second, can prices over-shoot to the downside.
Estimating marginal cost is more than just an academic exercise, equity shops like Macquarie Securities, consultants like Wood Mackenzie, industry associations, end users and the commodity producers themselves take the subject very seriously. I believe there's sufficient data to make close approximations of marginal costs. However, even if estimates are off by 5%-10%, it may not matter. Once conventional wisdom has established marginal cost, market participants tend to flock to it and make decisions based upon it.
Can Commodity Prices Over-Shoot to the Downside?
As to the question of commodities over-shooting to the downside, of course they can. There's no reason why coking coal prices couldn't fall to $150-$160 per metric tonne and iron ore to $90-$100. However, most agree that if that were to occur, it would not last long as loss making capacity would come off line. Also, it's important to know that while spot prices are a good indicator of market sentiment, 90% or more of coking coal and iron ore is sold on a contracted basis. Despite spot coking coal at $180 per metric tonne, Walter Energy's CEO said on August 2nd that he still expects the next quarterly settlement price to remain above $200.
Foolish investors are encouraged to do their own research and watch for signs of a bottom in these key commodities. Instead of waiting to hear about it along with everyone else on the planet, possibly after the impacted stocks have rebounded smartly, keep an eye out yourselves. A simple Google search is all it takes, search for the terms, "iron ore" and "coking coal," in quotes, and look at the news items sorted by date. If coking coal and iron ore spot prices have indeed bottomed, we could see rebounds in the above mentioned stocks soon after.