JPMIronore

www.jpmorganmarkets.com

Australia Equity Research

07 December 2014

Iron Ore

Further downgrades as supply overhang drives prices

ever lower

Metals & Mining

Mark Busuttil AC

(61-2) 9003-8619

[email protected]

Bloomberg JPMA BUSUTTIL

J.P. Morgan Securities Australia Limited

Lyndon Fagan AC

(61-2) 9003-8648

[email protected]

Bloomberg JPMA LFAGAN


Luke Nelson

(61-2) 9003-8618

[email protected]


Rodolfo Angele, CFA

(55-11) 4950-3888

[email protected]

Banco J.P. Morgan S.A.

Fraser Jamieson

(44-20) 7742-5930

[email protected]

J.P. Morgan Securities plc

See page 32 for analyst certification and important disclosures, including non-US analyst disclosures.

J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the

firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in

making their investment decision.

Since our last update in September 2014, iron ore spot prices have declined

another 12% as the introduction of even more capacity and the lack of a

typical seasonal restocking event have weighed on the market. With the low-

cost producers continuing to bring on more capacity (we estimate an

additional 17% of supply to come on between now and 2020), and demand

growth moderating, we believe the market will remain under pressure. As a

result, we have lowered our price forecasts to US$67/t in CY2015 (-24%),

US$65/t in CY2016 (-23%) and US$69/t in CY2017 (-16%). As we outline in

a separate report (link), we have reduced our long-term price to US$75/t.

Typical seasonal restock not happening as buyers appear happy to

maintain lower inventory: Iron ore prices typically increase towards the

end of the calendar year as Chinese steel mills build stocks ahead of the

Northern Hemisphere winter (which typically sees some domestic iron ore

production frozen over and shutdown). However, this has not occurred this

year, with buyers appearing unconcerned about availability and happy to

maintain lower levels of inventory given a significant amount of new

supply. The additional effects of the APEC summit (which saw a temporary

reduction in steel production) as well as a China domestic price premium

(which is supporting the high-cost producers) has meant prices have

deteriorated more than expected to the current spot price of US$71/t.

Pressure of supply overhang likely to continue to weigh on prices: We

estimate that 126Mtpa (62% Fe equivalent) of new capacity was introduced

by the big producers in 2014 (~6% of global supply). A further 341Mtpa is

expected to come on over the next five years from Vale, Rio Tinto, BHP

Billiton, Fortescue and Hancock alone, representing growth of 3.2% per

annum. With global demand moderating (we forecast 1.8% CAGR to 2020),

we believe the market oversupply will deepen in the near-term.

At this point, we see no reason why the low-cost producers will cut back

on capacity growth targets: With expected new capacity so far above

forecast demand, we believe the only way the oversupply can be averted is if

the low-cost producers cut back on their growth targets. However, at this

stage we believe this is unlikely: feedback from recent site visits to the

Pilbara suggests there is currently no consideration for slowing capacity

growth from either Rio Tinto or BHP Billiton. Vale indicated there is no

chance of slowing its S11D project (95Mtpa by 2017) because it is low cost

and high quality. Fortescue has reached capacity at its operations and will

look to reduce unit costs by maximising production. Hancock has already

committed much the capital for its Roy Hill project and therefore will look

to recoup its investment through project cashflows next year.

Reducing price forecasts: We have made a number of changes to our

supply/demand modeling including incorporating even higher production

rates from the low-cost producers, reducing our China steel production

growth forecasts, and lowering iron ore producer costs. The net impact is a

substantial downgrade to our iron ore price forecast.

Open cut iron ore mine in China

Source: J.P. Morgan

2Australia Equity Research

07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Near-term indicators continue to deteriorate

Since our last update on 29 September 2014, the overhang of excess supply and

weaker demand in China has resulted in further falls in the iron ore price. Todays

benchmark CFR price of US$71/t is 48% lower than US$134/t at the start of the

year. As shown in the chart below, prices are now at 5-year lows.

Figure 1: Benchmark iron ore price [US$/t CFR China]

Source: Bloomberg.

As we wrote in our previous update in September 2014, we had expected a seasonal

restocking event ahead of the Chinese winter (which typically sees some domestic

iron ore production frozen over and shutdown) resultng in a temporary pickup in

seaborne demand and prices through the December 2014 quarter.

While average prices for the quarter (of US$77/t to date) are close to our prior

forecast of US$80/t, a number of factors (including a lack of restocking) have

impacted demand and suggested weaker than expected near-term market conditions:

1. APEC steel production restrictions: According to our Asia Metals & Mining

Team, China steel production declined 2% in the months September and October

2014 from 832Mt (annualized) in August 2014 to 812Mt.

A large factor was the APEC meeting in Northern China: To ensure better air

quality during the meeting, the Chinese government implemented measures to

limit production from open pit mines and industrial sites in Beijing, Tianjin,

Hebei, Shanxi, Shandong, Inner Mongolia and other provinces.

With APEC now over, we believe steel output should recover from December.

However, year-to-date China crude steel output is up only 2.1% from the same

period last year, compared to our prior estimate of 3.0%.

2. Domestic price premium supporting high cost producers: As shown in Figure

2, China domestic prices (adjusted for VAT, grade and port charges) closely track

imported benchmark prices. While China prices have fallen in recent months, a

premium has emerged for domestic supplied product since the middle of 2014.

The current equivalent price in China for domestic iron ore is US$84/t, which is

US$13/t higher than imported iron ore.

While MySteel capacity utilization is now


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Figure 2: Benchmark iron ore price versus adjusted China domestic prices [US$/t CFR China]

Source: Bloomberg.

3. Lack of any significant restocking: The chart below shows iron ore inventories

at Chinese steel mills. As shown, the past three years has seen a significant

restocking event in the second half of the year. In particular, in 2013, inventories

increased from 400kt in June 2013 to 650kt by the end of the year. However, this

year there has been no such event.

Figure 3: Iron ore inventory levels at China steel mills

Note: The iron ore stockpile data is based on 64 small and medium sized steel mills across China.

Source: Mysteel, J.P. Morgan estimates.

Feedback from Baosteel in September 2014 suggested that the Chinese steel

producers are prepared to hold significantly less inventory on the basis that

supply is now readily available. Additionally, the lack of steel production growth

means that less inventory is required. Finally, credit availability is tighter which

could also be having an impact.

With the APEC summit now over and China steel production rates expected to

increase, there are reasons for some slight optimism for the balance of the year.

Additionally, feedback from traders suggest some signs of genuine buying in the past

few weeks which could mean that shorts begin to cover. However, we believe any

recovery will be muted with continued growth in low-cost supply far exceeding any

demand growth.

Therefore we are lowering our December 2014 quarter average price to US$75/t

implying an average price of US$73/t for the remainder of the period.

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07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Prices are likely to remain under pressure unless low-cost

producers reduce capacity growth

With iron ore prices likely to end the year in the US$70's (compared to our prior

CY2015 real price forecast of US$86/t), we believe it is necessary to revisit our

medium-term price forecasts given still more low-cost supply growth expected to

come on in the next 12 months.

Overall, we struggle to find reasons why prices can improve from current levels

unless low cost producers reduce capacity growth (which we believe is highly

unlikely), and therefore we have implemented further cuts to our forecast prices. We

have also revisited our long-term price estimate on the basis of additional

information from low-cost producers (refer separate note link).

The net changes are shown below. We expect a slightly stronger March 2015

although this is completely reliant on seasonal iron ore production interruptions.

With additional supply coming online next year, we expect further declines in prices

in the second and third quarters of 2015 before a seasonal restocking event lifts the

December 2015 quarter price. Overall, we estimate an average price in CY2015 of

US$67/t, 31% lower than US$98/t in CY2014.

Table 1: New iron ore price forecasts [US$/t in nominal terms except long-term which is in 2014 dollars]

US$/t Q1a Q2a Q3a Q4e 2014e Q1e Q2e Q3e Q4e 2015e 2016e 2017e 2018e L-T (real)

New 120 103 92 75 98 75 65 60 65 67 65 69 70 75

Old 120 103 92 80 99 - - - - 88 84 82 85 80

Change n/c n/c n/c -6% -1% n/a n/a n/a n/a -24% -23% -16% -18% -6%

Source: J.P. Morgan estimates

In our view, the three key factors to consider over the medium term are:

1. Will the big producers continue to expand supply irrespective of prices?

Despite the market already being in oversupply, continued capacity expansion

from the big four producers (Vale, Rio Tinto, BHP Billiton and Fortescue) will

likely see an additional 292Mtpa of supply coming on in the next five years.

Adding likely growth from Hancock sees incremental supply growth of 341Mtpa

by 2020. As shown in the chart below, this far exceeds estimated incremental

global demand which we estimate to grow at only ~1.8% per annum.

Figure 4: Cumulative supply growth versus global demand growth [Mt iron ore 62% Fe dry]

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2014 2015 2016 2017 2018 2019 2020

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Our supply and demand model

is shown on page, and the main

changes we have made to our

modeling are shown on page 17.


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Source: J.P. Morgan estimates, company data

To date, the big producers have shown no interest in reducing capacity growth

(despite the obvious impact this new supply is having on prices) insisting they are

price takers and curtailments will only come from the high-cost producers. While

there are three dynamics at play, overall we believe the incentive for all of the

large producers is still to keep expanding capacity:

Hancock: For Hancock, having already committed ~A$10 billion to develop

the Roy Hill project, we believe it would be highly unlikely the company

would cease construction less than one year ahead of first production. We

currently estimate the project has all-in costs of ~US$60-$70/t CFR which is

still profitable (albeit somewhat marginal) at current prices. Therefore, we

believe the project will proceed despite weak prices.

Fortescue: We estimate Fortescues all-in costs before interest payments are

currently in the high US$60s/t CFR meaning that the company is barely cash

flow positive at current spot prices.

Fortescue management has not given any indication at this stage of anything

other than production as usual. However, with prices declining rapidly in

recent weeks, we believe the company is likely reviewing contingency plans.

In our view, the first target will be the implementation of additional cash

saving measures (such as reducing capex, and exploration).

Should prices continue to deteriorate (beyond what can be offset by cost

reductions) the next target could be an adjustment to mine plans. The high

strip ratio Chichester mines will likely be the focus and the company could

selectively mine to reduce costs, but this will sterilize part of the orebody.

While this could be an avenue where global supply gets curtailed, we believe

iron ore prices would likely need to be at least ~US$10/t lower on a prolonged

basis to be considered by management.

Vale, BHP Billiton and Rio Tinto: ~80% of the new capacity growth

between now and 2020 is coming from the three largest, lowest-cost

producers. Feedback from recent site visits to the Pilbara suggests there is

currently no consideration for slowing capacity growth from either Rio Tinto

or BHP Billiton. This is largely because the three majors can exceed hurdle

rates for brownfield projects even at much lower iron ore prices.

Furthermore, Vale indicated there is no chance of slowing its S11D project

(95Mtpa by 2017) because it is low cost and high quality, which means the

lower prices make the project more compelling. However, the company

indicated it could substitute other productions outside Vale or even inside

Vale that have a higher cost and lower quality.

After almost a decade of rapid capacity growth, the biggest producers appear

to have slack in their systems, which allows for low-cost brownfield capacity

growth for the foreseeable future. BHP Billiton has guided cap-ex of

~US$30/t for its expansion to 290Mtpa by the end of FY2017.

If we assume brownfield project expansions cost US$30/t of incremental

supply, then BHP Billiton and Rio Tinto can generate nominal IRRs of +30%

assuming current prices over the life of the project.

Longer-term, assuming more normal greenfield project cap-ex of US$150/t,

the low-cost producers can still generate a 15% nominal IRR at prices of


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

US$73/t. These scenarios are discussed more in our research report on long-

term prices (link).

2. How much cost out can occur and how long will high-cost production run at

losses? As shown in the chart below, excluding the big four producers and

Chinese state-owned enterprises (SOE), we estimate only 40% of supply is

actually making money at the current benchmark price of US$71/t.

Figure 5: Current China landed cost curve [US$/t]

Source: J.P. Morgan estimates.

Should the ~245Mtpa of production that is current required but operating at

losses curtail operations, the market would quickly move to undersupply and

prices would therefore need to increase. However, it takes time for loss-making

assets to reduce output, and the speed of the price decline in recent months means

that these companies are probably looking at cost reductions in the first instance

to improve profitability.

Figure 6: Breakdown of current supply

Source: J.P. Morgan estimates

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China SOE

RIO BHP Vale FMG

Mt supply

Current price

Approximately 21% of supply is

loss-making at current prices

US$/t

Big four producers 54%

Other unprofitable 21%

China SOE 17%

Other profitable 8%


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Additionally, the low-cost producers are also targeting cost reductions:

Vale: Vale expects its iron ore cash costs to decrease even further driven by

higher production, diluted fixed costs and internal cost reduction initiatives. A

depreciated Brazilian real versus the dollar is also expected to contribute to

the reduction of the companys cash costs.

BHP Billiton targeting US$20/t FOB costs: At its most recent site visit to

the Pilbara, BHP Billiton management provided definitive targets to reduce

operating costs at WA Iron Ore from US$25.89/t in H2 FY2014 to US$20/t

in the medium term. Additionally, average sustaining capital would be

lowered to US$5/t for the next 5 years.

RIO Tinto already achieving US$20/t costs: In October 2014, Rio Tinto

indicated that cash unit costs at its Pibara operations had decreased ~15%

over the last 2 years to US$20/t. The company highlighted the embedded

culture of cost discipline and indicated that there were over 200 cost

reduction and productivity improvement projects underway.

Fortescue has lowered costs by 33% in 3 years: Perhaps most

impressively, Fortescue's costs have decreased from US$48/wmt in 2011 to

US$32/wmt in the most recent quarter driven by lower strip ratios at

Solomon, enhanced processing, and productivity efficiencies amongst other

things. Costs are expected to fall a further 10% at least to be below

US$30/wmt in FY2015.

3. What will be the impact of slowing China steel production growth on

demand? As shown in the table below, we assume total iron ore demand growth

of 3.0% in 2014 slowing to 1.5% in 2015 and 2.1% in 2016.

Table 2: Iron ore demand growth forecasts

2011 2012 2013 2014e 2015e 2016e 2017e 2018e 2019e 2020e

Oceania -11.2% -26.1% -5.0% -3.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0%

South America 9.5% -16.0% -7.1% -1.5% 2.2% 3.3% 3.3% 3.3% 3.3% 3.3%

Africa & Middle East 4.7% 6.3% 13.3% 5.0% 7.3% 6.7% 6.7% 6.7% 6.7% 6.7%

North America 7.4% 4.4% -3.4% 2.0% 2.6% 2.6% 2.6% 2.6% 2.6% 2.6%

CIS 2.8% 2.1% 0.1% 0.0% 2.5% 3.0% 3.0% 3.0% 3.0% 3.0%

Europe 0.3% -3.0% 1.7% 3.5% 3.1% 2.8% 2.8% 2.8% 2.8% 2.8%

China 9.7% 5.5% 5.8% 2.0% 0.0% 1.0% 2.0% 2.0% 2.0% 2.0%

India 4.2% 3.8% 1.4% 7.1% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5%

Japan & Korea 5.0% -0.1% 1.5% 3.7% 1.6% 1.3% 1.3% 1.3% 1.3% 1.3%

Other Asia 19.4% -7.3% 16.6% 2.5% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

Total demand growth 7.3% 2.7% 3.9% 3.0% 1.5% 2.1% 2.8% 2.8% 2.8% 2.9%


As expected, the majority of the reduced growth is coming from China where we

project steel production to increase 2.0% in 2014, 0.0% in 2015 and 1.0% in 2016

compared to the average growth rate of 10.0% over the last five years.

We have reduced our Chinese steel production growth rate from 3% to 2% for

2014 and from 2% to 0% in 2015. Weak domestic demand is the key driver

behind our downgrades - we estimate apparent demand (including inventory

movements) for the first 10 months of the year has fallen to -0.2%, the first fall in

nearly 20 years.

In our view, China's slumping property sector (which accounts for ~50% of steel

demand) is the dominant driver of poor domestic consumption. While we expect


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

property sales to pick up in the near term as a result of easing policies, J.P.

Morgan expects real estate investment to remain weak given high property

inventory levels of ~18 months. Infrastructure and durable goods (autos,

machinery) demand have provided some offset but growth is forecast to slow

going forward.

Fortunately for Chinese mills, exports have surged (near doubling) this year,

providing a release valve for surplus output. We forecast export growth to slow,

given rising anti-dumping complaints but given weak domestic demand, we do

not expect exports to fall.

As China continues to drive toward its urbanisation targets, we forecast 2016

steel output to stabilise at 1% growth with 2% growth from 2017 onwards.

Based on our forecasts, we expect Chinese steel production to only exceed

900Mtpa by 2020. As shown below, our forecasts are calling for an inflection

point in steel production but this is supported by recent data.

Figure 7: Annual Chinese steel production

Source: J.P. Morgan estimates, World Steel

In our analysis we also assume that the proportion of steel produced via the

electric arc furnace increases from ~9% currently to 15% by 2020. We include a

detailed analysis of increasing scrap in our separate note on long-term prices

(link).

Notwithstanding these demand assumptions, we forecast total supply growth

from the big four producers of 6% CAGR between 2014 and 2018. Even the

most optimistic assumptions for demand are likely less that total new capacity

and therefore the key driver of prices remains the supply side.

Figure 8: Production forecasts from the big four producers [Mt]

Source: J.P. Morgan estimates, Company data.

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07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Key company specific events since our last update

Vale: Vale announced record production rates in the September 2014 quarter

(343Mtpa annualized excluding Samarco) with gains in all production Systems

when compared to the June 2014 quarter. The good operational performance was

supported by the ramp-ups of Plant 2 in Carajs and of Conceio Itabiritos in the

Southeastern System.

Rio Tinto: At its November 2014 investor seminar, Rio Tinto reiterated the

companys commitment to growth in its Pilbara operations indicating the

expansion to 360Mtpa is expected to deliver an IRR of 40% with a five-year

payback period. The company noted the Pilbara assets have produced an average

EBITDA margin of 50% and the 360 project positions the business for industry-

leading returns over the long term.

BHP Billiton: Iron Ore Division President Jimmy Wilson's presentation in

October 2014 reiterated key messages outlined at the companys prior site tour:

the WA Iron Ore assets are at the front line of BHP Billitons productivity agenda

and expansions will be sourced from de-bottlenecking existing infrastructure and

not from new mine developments.

Fortescue Metals: At a site visit in October 2014, management reiterated the

companys focus on optimizing system capacity to the ultimate bottleneck which

will be the car dumpers at 180Mtpa once the fifth berth is online in April 2015.

However, following the decline in iron ore prices, capex has been cut, the 5mtpa

US$105m detritals plant has been deferred, and the company is likely to

restructure the business to have production below system capacity for some time.

Vedanta: Production restarted at the Karnataka asset in the September 2014

quarter following a partial resolution of Indias iron ore mining ban, but the ban

remains at Goa. However Karnataka ceased producing in August 2014 as it

awaits its mining license renewal and a forestry clearance, which Vedanta expects

to receive before the end of 2014. In Goa, Vedanta expects mining to resume in

the March 2015 quarter, following an expected issuance of new mining leases in

October 2014. We forecast Goa production re-starts in the March 2015 quarter at

0.5Mt, and reaches 10.7Mt in FY2016. It remains to be seen whether many

Indian producers could compete in the export market at current prices.

Mount Gibson Iron: In October 2014, Mount Gibson announced a pit-wall

slippage had occurred at the 4Mtpa Koolan Island Main Pit and as a result,

mining operations within the area were suspended. The company announced that

a further slump in the Koolan Island sea wall occurred on 25 November which

(following a high tide) resulted in flooding of the Main Pit. The full extent of the

situation is still being evaluated, although at this stage mining within the Main Pit

remains suspended and there is no update to the companys full year production

guidance that was provided in early November.

Anglo American: Anglo American made the first shipment on 27 October 2014

from its Minas-Rio iron ore project in Brazil. The first cargo of more than 80,000

metric tons was loaded at the port of Au. The company expects the project to

ramp up to its capacity of 26.5Mtpa over the next 18 to 20 months.

10


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Cliffs Natural Resources: Following another quarter of Bloom Lake cash costs

above US$80/tonne (excluding the rail take or pay) our North American Metals

& Mining team believes prior management teams target of cash costs sub-

US$80/t in the December 2014 half on a standalone Phase I does not appear

feasible. During the September 2014 earnings call, the current team outlined its

progress to finding a solution by year end which could include JV partners in

the project to develop Phase II at an estimated cost of US$1.2 billion; roughly

US$450 million of construction costs and US$750 million for tailings incurred

over a multi-year time frame.

The potential partnership would include equity investments and accompanying

offtake agreements with as many as three steel producers. An agreement, if

reached, is slated to occur ahead of year end 2014. Based on these potential

commitments and existing agreement with Wuhan, management indicated Phase

II would be fully booked and targeted cash costs in the low US$50/t range.

On October 31 the Wall Street Journal reported on Nucors interest in forming a

joint venture with two Japanese steel producers for an investment in Cliffs

Bloom Lake mine.

Sphere Minerals: According to Bloomberg, Sphere Minerals Ltd. (controlled by

Glencore), slowed plans to develop a US$900 million iron ore mine in Africa

after prices of the steelmaking material plunged. The board is reviewing the

Askaf project in Mauritania, after approving development in April 2014. Askaf

North had been expected to begin output in early 2017 and is forecast to yield

about 7.5Mtpa once developed.

CAP: Chilean steelmaker and mining firm CAP has postponed two iron ore

expansion projects; Cerro Negro Norte (CNN) mine ramp up and Phase 5 of the

Romeral mine. No new dates have been given by the company. Previously the

CNN and Romeral developments were planned to lift CAPs output from 12Mtpa

in 2013 to 15Mtpa in 2014 and 18Mtpa by 2015.

Atlas Iron: As part of Atlas cost reduction program targeting A$65-$90 million

in annualised savings by June 2015, the companys Directors (inclusive of the

Managing Director) offered to reduce their remuneration by 15%, effective 1

December 2014.

London Mining: Timis Corporation, the founder of African Minerals, agreed to

buy London Minings Marampa mine after the latter entered administration on 16

October 2014. Negotiations with African Minerals and its infrastructure company

are planned to unlock the synergies between Marampa and African Minerals

Tonkolili project. In 2013, African Minerals and London Mining shipped 15.5Mt

of iron ore from their operations in Sierra Leone.

African Minerals: In early December 2014, African Minerals Limited, the

developer, operator and 75% owner of the Tonkolili Iron Ore Project in Sierra

Leone indicated that their operations would be placed on care and maintenance

due to insufficient working capital. According to the companys release, the

project has been severely impacted by low iron ore prices, which has prevented

implementation of cost reduction strategies.

11


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Feedback from our iron ore traders

Chinese mills have de-stocked over the past 10 days, going against market

expectations of a restock, which partially explains some of the recent weakness in

iron ore. Following the recent uptick in iron ore prices on more positive China

sentiment, our traders are saying they have seen the first signs of genuine buying in

the past few weeks, and their view is some of the shorts will now think about starting

to cover, which could see the price supported somewhat to year end.

Feedback from our recent commodity tour of China

Our Global Metals & Mining team recently visited Chinas commodity producers in

Beijing, Hebei and Shanghai last week. Many producers are hopeful that policy

support, environmental restrictions, capacity closures, and exports will help markets

rebalance but the pace and level of commitment remains difficult to judge. Key

highlights on the iron ore and steel markets:

Iron ore private mines on the brink of heavy closures: Iron ore companies

are barely cash breakeven, even after recent tax relief from local governments.

According to Antaike (industry consultant), Chinas raw iron ore mine capacity

is 1.6Bt but only 500mt at an equivalent 62% Fe grade. The bottom 40% of the

industry (500mt) operates at cash costs lower than US$80/t, with the next 20% at

US$80-$100/t, the following 20% at US$100-$120/t, and the remainder at

>US$120/t.

Our visit to a low-cost private mine with cash costs of ~US$75/t on capacity of

0.4mtpa (66% Fe) suggests that many are on the brink of closure. It was a similar

story (i.e. likely closure) for the independent beneficiation plant we visited. In

contrast, Hebei Iron & Steel (HBIS, SOE) indicated that many of its mines (under

its parent group) will continue to operate despite cash losses.

Steel exports likely to stay, resilience in high end demand: Given weak steel

demand (apparent demand down c1% year-to-date), our discussions with industry

players suggest a likely deferral of any changes to existing steel export rebate

policy.

Antaike forecasts 2015 demand growth of 1%, with 1-1.5% in 2016-17, while

HBIS, Shougang and Baosteel expects flat (high end) steels to enjoy higher

growth rates. Environmental standards to be implemented by Jan 2015 have the

potential to restrict steel production as smaller players are unlikely to be able to

meet conditions (given cost and lack of access to funding), but it is uncertain how

strictly these would be imposed.

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07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Figure 9: Open pit iron ore mine in Qian'an Malazhuang (November 2014)

Source: J.P. Morgan

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07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Figure 10: Underground iron ore mine and concentrator in Shunkang (November 2014)

Source: J.P. Morgan

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07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Lowering iron ore price forecasts again

We have made some changes to our supply/demand modeling including:

1. Incorporating even higher production rates for the big four producers: We

now forecast total iron ore production of 1305Mtpa from Vale, Rio Tinto, BHP

Billiton and Fortescue by 2020 (62% Fe equivalent dry). This is 3% higher than

our previous forecast of 1261Mtpa.

2. Reducing our China steel production growth forecasts: Our new steel

production growth estimates are 2.0% in 2014, 0.0% in 2015, and 1.0% in 2016.

We have also assumed steel produced from scrap increases from 9% in 2014 to

15% in 2020.

3. Lowering iron ore producer costs: As discussed previously, Rio Tinto, BHP

Billiton, and Fortescue are all targeting reduced operating costs, and the higher

cost producers are also looking to lower costs to improve profitability. We have

included lower production costs across the board in our modeling which

effectively lowers the cost curve.

4. Unprofitable mines remain operating for longer: Over the last decade, the

market has effectively been in deficit meaning that all supply was required. With

no historical datapoints to rely on, potentially the most difficult assumption in our

modeling is how much supply will remain online when unprofitable. With

approximately 25% of the market unprofitable and operating today, we have

lowered our marginal cost assumption to 80% in 2015 before moving back to a

steady state 90% in 2018 and beyond.

As shown in the chart below, we expect prices to remain under pressure until at least

mid-2016.

Figure 11: Iron ore prices - historical and forecast [US$/t CFR China nominal]

Source: Bloomberg., J.P. Morgan estimates

$104

$133

$128

$133

$98

$67$65

$69 $70$74

$76

60

70

80

90

100

110

120

130

140

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

15


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Lump and Pellet Premiums have been strong

Bucking the trend of the recent collapse in iron ore spot prices, lump and pellet

premiums have been strong and on the move up. This has helped contain the price

decline in both pellet and lump prices while iron ore fines have corrected 18%

since the end of August, pellet prices have declined only 9% and lumps prices have

been flattish with only 1% decline.

We attribute the uptick in lump/pellet premiums to two reasons: (1) bulk of the

supply brought on-stream this year was of iron ore fines, so consequently that is the

market seeing the maximum weakness, and (2) Pollution control measures by

Chinese authorities have limited sinter production in the regions surrounding Beijing.

As such, demand for lumps and premiums have gone up from steelmakers in that

region, which coupled with tight supply has pushed the premiums to levels more than

double their 2-year average.

A tighter market for lumps (relative to pellets) is the reason we have seen a stronger

increase in lumps premiums, as there are three simultaneous ramp-up of pellet

capacities at Samarco IV, Tubarao VIII and Vales Oman pellet plant.

Figure 12: Pellet premiums have been strong

$/t

Source: J.P. Morgan estimates, Bloomberg.

Note: The graph represents real pellet price premiums after adjusting for the Fe grade.

Figure 13: Lump premiums have reached more than double their 2-year average, but likely

temporary

$/t

Source: J.P. Morgan estimates, Bloomberg.

Note: The graph represents real pellet lump premiums after adjusting for the Fe grade.

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14

Pellet Premium Average +1 SD -1 SD

-

5.0

10.0

15.0

20.0

25.0

30.0

Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14

Lump Premium Average +1 SD -1 SD

16


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

The spike in premiums likely temporary, we see more downside in lump

premiums

Having said that, we believe it is unlikely that lump premiums would sustain

themselves at the current level of ~$25/t. The pollution control measures by China

are temporary and thus should stop being a supportive factor soon. We expect a

move in lump premiums towards their 2-year average of ~$11/t as the first step of

normalization. Pellet premiums at $34/t are relatively closer to their 2-year average

of $28/t, so we see relatively limited downside in those.

17


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Table 3: Supply and demand model [dry metric tonnes @ 62% Fe equivalent]

IRON ORE DEMAND 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Oceania 10 9 6 6 6 6 7 7 7 7 7

South America 57 62 52 48 52 53 55 57 59 61 63

Africa & Middle East 49 51 54 61 67 73 78 83 89 95 101

North America 72 77 79 77 83 85 88 90 92 95 97

CIS 135 138 141 141 135 138 144 148 152 157 162

Europe 153 153 150 153 157 163 168 172 177 182 187

Other Asia 161 179 179 132 146 158 171 185 200 215 232

Japan & Korea 179 188 188 189 201 205 207 210 213 215 218

China 886 999 1045 1194 1190 1168 1166 1179 1189 1199 1208

Total iron ore demand ** 1701 1856 1895 2002 2037 2051 2083 2131 2178 2226 2276

Growth 9.1% 2.1% 5.7% 1.8% 0.7% 1.6% 2.3% 2.2% 2.2% 2.3%

China 12.8% 4.6% 14.2% -0.3% -1.9% -0.2% 1.1% 0.8% 0.8% 0.8%

Ex-China 5.1% -0.8% -4.9% 4.9% 4.2% 3.8% 3.9% 3.8% 3.9% 3.9%

Total blast furnace production 1123 1205 1238 1286 1317 1327 1347 1376 1406 1437 1469

IRON ORE SUPPLY 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Oceania 392 434 478 562 683 743 751 776 794 803 820

South America 415 439 431 414 412 437 510 507 547 565 574


North America 93 101 104 106 115 113 95 95 91 91 91

CIS 169 178 183 185 190 181 183 184 181 183 184

Europe 38 40 41 43 43 44 46 49 52 52 52

Other Asia 199 194 156 157 161 133 146 154 160 166 173

Japan & Korea 0 0 0 0 0 0 0 0 0 0 0

China 289 360 373 381 295 283 252 245 228 238 251

Total iron ore supply 1701 1856 1895 2002 2037 2051 2083 2131 2178 2226 2276

Growth 9.1% 2.1% 5.7% 1.8% 0.7% 1.6% 2.3% 2.2% 2.2% 2.3%

BALANCE 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Oceania 383 425 472 556 677 737 745 769 787 796 813

South America 357 377 379 366 360 383 455 450 488 504 510


North America 21 24 24 29 32 28 8 5 -1 -3 -6

CIS 34 40 42 44 55 43 39 36 29 26 22

Europe -115 -114 -108 -110 -114 -119 -122 -123 -125 -129 -134

China -597 -639 -672 -813 -895 -885 -915 -934 -961 -961 -957

Other Asia 38 15 -23 25 15 -26 -25 -31 -40 -49 -59

Japan & Korea -179 -188 -188 -189 -201 -205 -207 -210 -213 -215 -218

Total 0 0 0 0 0 0 0 0 0 0 0


** includes stocking and destocking of iron ore

18


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Ap

pe

nd

ix 1

F

ore

ca

st

co

st

cu

rve

s

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07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Figure 14: 2013 cost curve (real)


0

50

100

150

200

250

0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400

97th percentile cost: US$133/t

BHP FortescueRIOVale

China SOE

Cost of production [US$/t landed China]

Cumulative supply [mt]

20


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]



0

50

100

150

200

250

0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400


BHP FortescueRIO Vale

China SOE



21


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]



0

50

100

150

200

250

0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400



China SOE



22


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]



0

50

100

150

200

250

0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400



China SOE



23


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]



0

50

100

150

200

250

0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400



China SOE



24


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]



0

50

100

150

200

250

0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400



China SOE



25


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Ap

pe

nd

ix 2

F

ore

ca

st

se

ab

orn

e t

rad

efl

ow

s

26


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

Figure 20: 2013 seaborne tradeflows


100Mt

Australia, 562Mtpa

South America, 414Mtpa

Africa & Middle East, 154Mtpa

North America, 106Mtpa

CIS, 185Mtpa

Other Asia, 157Mtpa60Mt

182Mt

11Mt

81Mt

407Mt

150Mt

29Mt

11Mt

Total Production

47Mt

110Mt

2013

39Mt

34Mt

XXXMt Import quantities

221Mt

Dry metric tonnes normalised to 62% Fe

27Mt

27Mt

Europe

778Mt

188MtChina

Japan & Korea

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07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]



100Mt

Australia, 683Mtpa




CIS, 190Mtpa


232Mt

18Mt

53Mt

526Mt

151Mt

32Mt

25Mt

Total Production

40Mt

114Mt

2014

49Mt

30Mt


281Mt


27Mt

27Mt

Europe

909Mt

200MtChina

Japan & Korea

28


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]



100Mt

Australia, 750Mtpa




CIS, 191Mtpa


251Mt

17Mt

51Mt

590Mt

153Mt

36Mt

24Mt

Total Production

40Mt

119Mt

2015

50Mt

29Mt


301Mt


27Mt

27Mt

Europe

988Mt

204MtChina

Japan & Korea

29


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]



100Mt

Australia, 822Mtpa




CIS, 194Mtpa


325Mt

18Mt

54Mt

661Mt

155Mt

35Mt

23Mt

Total Production

40Mt

122Mt

2016

51Mt

28Mt


376Mt


27Mt

27Mt

Europe

1135M

206MtChina

Japan & Korea

30


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]



100Mt

Australia, 857Mtpa




CIS, 194Mtpa


345Mt

19Mt

56Mt

693Mt

157Mt

33Mt

21Mt

Total Production

40Mt

123Mt

2017

52Mt

25Mt


396Mt


27Mt

27Mt

Europe

1186M

209MtChina

Japan & Korea

31


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]



100Mt

Australia, 874Mtpa




CIS, 194Mtpa


374Mt

17Mt

52Mt

708Mt

159Mt

27Mt

19Mt

Total Production

40Mt

125Mt

2018

52Mt

23Mt


426Mt


27Mt

27Mt

Europe

1224M

212MtChina

Japan & Korea

32


07 December 2014

Mark Busuttil

(61-2) 9003-8619

[email protected]

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[email protected]

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Near-term indicators continue to deterioratePrices are likely to remain under pressure unless low-cost producers reduce capacity growthKey company specific events since our last updateFeedback from our iron ore tradersFeedback from our recent commodity tour of ChinaLowering iron ore price forecasts againLump and Pellet Premiums have been strong

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