COLUMN-Iron ore, an ugly market about to turn uglier still: Andy Home

(Repeats MARCH 20 column, no change to text)

By Andy Home

LONDON, March 20 (Reuters) - The iron ore market is turning ever more ugly.

The price of ore for immediate delivery to China's Tianjin port is currently assessed by The Steel Index (TSI) at $54.50 a tonne.

That's a record low or at least the lowest since TSI started tracking the spot price back in October 2008.

Such a cataclysmic collapse was never in the script.

Sure, price weakness was expected. How could it not be when the world's biggest producers were collectively bringing so much new capacity on stream? But no one expected this sort of carnage.

The two central tenets of the iron ore producer faith are crumbling before their eyes.

The first was that Chinese steel production, and therefore Chinese iron ore buying, had years of steady growth ahead of it.

"Peak steel" was pencilled in for the next decade, an assessment that looks ever more questionable as China's steel producers reel from a toxic mix of slowing demand from the property sector, an environmental clamp down and relentless margin pressure.

The second was that new, lower-cost supply would neatly displace higher-cost producers, bringing the market back into balance.

This "cost-curve" argument has been used by all the "big three" majors, Rio Tinto (Xetra: 855018 - news) , BHP Billiton (NYSE: BBL - news) and Vale , to justify to shareholders why they are bringing on more production at the time when Chinese demand for their product is looking decidedly shaky.

It too, though, is now starting to look highly problematic.

The tricky thing with cost curves, as analysts at Liberum Capital (Other OTC: CGHC - news) point out, is that they "are at best estimates, are highly fluid and have been terrible predictors of commodity prices." ("The Miner Details", March 17, 2015)

WHO TOOK OUR COST CURVE?

Only eight months ago, when the iron ore price had just fallen through the $100-per tonne level, analysts at Macquarie Bank put out a research note with the reassuring title: "Orderly iron ore displacement increases confidence in the cost curve". ("Commodities Comment", July 22, 2014)

This week's research note, accompanying another price downgrade, carried a far more ominous title: "Iron ore: a nasty end to market efficiency". (Commodities Comment, March 17, 2015)

The problem is that in the space of the intervening eight months the iron ore cost curve has flattened to the point that it's less of a curve, more of a gently rising slope.

In part this is due to the "efficient" closure of supply sitting at the top end of the curve, particularly that part coming from the small independent production sector in China itself.

Such "swing" supply had been seen to exit before on price weakness, explaining why Macquarie back in July could confidently claim that "with the relatively rapid exit of supply as prices fell, the veracity of the cost curve data has been tested and validated."

But what analysts at CRU term "the low-hanging fruit" has now gone. ("Evaluating iron ore displacement in China", March 17, 2015)

Everyone else, meanwhile, has been slashing costs, a process aided and abetted by the depreciation of key producer currencies and tumbling freight rates.

The cumulative result, Macquarie now concedes, is that "with everyone doing the same thing, the net effect has been a significantly lower cost curve but limited change in supply to the wider market."

So the cost curve has changed shape. It is now both flatter and lower, attesting to the sort of fluid dynamics highlighted by Liberum.

A WAR OF BALANCE SHEET ATTRITION

But the need for more displacement is greater, particularly since Australian seaborne supply is going to increase again this year thanks to a production rise by Rio Tinto and the new Roy Hill mine due in September.

Which is where things are about to turn uglier still.

CRU contends that the next major cuts will also have to come from China, but with the opportunistic higher-cost producers already gone, this means closures of bigger state-owned operators or those that are vertically integrated into the steel sector.

Such supply may prove highly sticky with simple cost considerations likely to be intertwined with strategic pressures, both commercial and governmental, to stay open.

Outside of China the scene is being set for a brutal war of attrition, from which only those with sufficient financial reserves will survive.

"It is likely that balance sheet strength, rather than cost curve position, will ultimately determine the timing of further exits of supply," according to Andrew Harding, Rio's iron ore chief, speaking at the recent Global Iron Ore and Steel Forecast Conference in Perth.

Rio, it goes without saying, thinks it has both the low costs and the balance sheet to weather the price storm. What its shareholders make of this new survival metric, however, is another matter.

THE DARWINIAN WAY

There is no terminal iron ore market to help out cash-strapped producers. Supply and demand will only be balanced the Darwinian way when enough producers are forced out of business.

The price is the mechanism through which this will happen, which is why Macquarie, a previous bull voice in iron ore, has just cut its forecasts again to $54 this year and $58 next year, including a predicted dip below $50 in the third quarter of 2015.

The scale of corporate blood-letting could be extreme.

Liberum analysts, for example, write that "if demand is flat for four years (possible in our view), planned new supply additions will push out all but 70 million tonnes of non 'big four' production."

That's the current "big three" producers plus new kid on the Pilbara block, Fortescue.

They go on to argue, "it seems clear then, that at some point in the next 24 months Fortescue and Roy Hill will be the new marginal producers." Because just about everyone else will have gone.

If they're right, iron ore is going to go down in commodity market history as one of the most spectacular boom and bust stories ever seen, which is saying a lot given the number of contenders for that particular claim to infamy.

And if you're of a sensitive disposition, you may want to look away for the next chapter.

(Editing by Jason Neely)