What's not to like about skyrocketing iron ore prices?

Key points: Iron ore prices have surged to their highest level in five years on the back of mine shutdowns in Brazil

Iron ore prices have surged to their highest level in five years on the back of mine shutdowns in Brazil Chinese steel mill margins are being crushed and some have returned to making losses

Chinese steel mill margins are being crushed and some have returned to making losses Consensus forecasts see iron ore prices sliding back below $US80/tonne in coming years, but mines will still be very profitable

They paper over all manner of blemishes in the Australian economy and help recession-proof the "lucky country" further over the horizon.

On Treasury figures, a $US10 rise above the (currently) conservative estimate of $US55/tonne, nominal GDP could be boosted by around $25 billion this year and the already stronger budget position will have $4 or $5 billion head start even before the next tax year begins.

That's a significant boost to the national income, which in turn lifts living standards.

Superannuants and investors benefit not only from the rising tide of the big miners' share prices, but also the dividends they are shovelling out.

The current dividend yields of BHP and Rio Tinto of around 6 or 7 per cent line up favourably against the big banks, and more than favourably against the near zero return you get for lending your "hard-earned" to the banks (which lend it back to you at higher rates).

Iron ore price sensitivities

+/- $10/tonne movement in iron ore price 2019/20 2020/21 Nominal GDP +/- $6.3b +/- $13.6b Tax receipts +/- $1.1b +/- $3.7b

Source: Federal Budget, 2019.

Can it last?

"This time it's different" is one of the more unnerving phrases in market, and generally a signal to bail out once it becomes group think.

What is perhaps striking about the latest surge in prices is this time no one appears to be saying "it's different". That in itself may give the rally a few more legs.

But there are some distinct differences from the real boom years.

The current price approaching $US120/tonne is still well short of the record $US191/tonne in early 2011, or the $160/tonne reached in the last big rally seven years ago.

That last spurt was pretty well the death knell for phrases such as the "super commodities cycle" and "stronger for longer".

Up until then, Chinese GDP growth, and its seemingly insatiable appetite for steel, had led iron ore prices onwards and upwards.

Two things happened.

The boom had driven a massive expansion in mining capacity and the Chinese economy slowed. Supply up, demand down, prices inevitably fall — the first lesson in Economics 101.

What's different?

The Chinese economy may have slowed, and will slow further, but that doesn't mean it has stopped. Peak steel consumption, on some estimates, is still five or six years off.

Much of the recent acceleration in price is due to the supply, rather than demand side of the ledger.

But it is a more short-term, rather than long-term supply issue.

Another dam disaster in Brazil, this time at Vale's Feijao mine, which killed around 250 people (the death toll is still rising), has scuttled around 6 per cent of seaborne supply since late January.

Iron ore inventories at Chinese ports have dwindled away to the lowest level in more than two years.

To extent, Australian miners are innocent and enriched bystanders to recent events. They appear not be falling for same mistakes they made last time.

Iron ore is being shipped out at near record pace. ( supplied: Roy Hill )

"Australian producers are focussing on value over volume," CBA commodities analyst Vivek Dhar says.

"Delivered cost of Australian iron ore into China is around $US30/tonne. If you're selling it at $US112/tonne you have quite a healthy margin.

"They are dealing with the cash flow boost by either giving it back to shareholders, investing in further cost-cutting or reducing debt."

Veteran UBS analyst Glyn Lawcock says the big miners are not spending on expansion; all the money set aside for West Australian operations has been in replacing mines facing exhaustion.

"Australia is now running at near record levels of production, May was the second best month on record," Dr Lawcock said.

"Yes we have windfall prices, but it is a five-year journey through design, approval and building to get new mine capacity. Vale will be back before then."

Chinese steel mills squeezed

The capacity of Chinese steel mills to pay is another factor putting a ceiling on the price.

While demand for steel has eased, the soaring cost of raw materials has arguably hurt profitability more.

"There are some cases where Chinese steel mills are already unprofitable particularly with hot-rolled coil steel; steel for manufacturing has been under the pump on the back of the US/China trade war. Rebar steel is doing a bit better on the back of construction and infrastructure spending," Mr Dhar said.

The profitability of Chinese steel mills is tumbling. ( Source: CBA, Bloomberg )

However, like Australian miners, Chinese steel mills are now on a sounder footing to deal with swings in fortune.

Steel profitability has risen over recent years as government policy removed inefficient, and often illegal, producers. Utilisation rates have lifted as part of a structural shift.

Most of the unsustainable mills were shuttered in 2016 and 2017. There has been only a minimal decline in capacity recently.

Profitability in Chinese steel mills hit record levels in 2018. ( Hugh Brown (supplied) )

"Chinese steel industry went through a period of record profitability, last year there were super-abnormal profits. This year they're having a bad time," Dr Lawcock says.

"Chinese steel mills will have a tight year from a margin point of view, but they put away a lot last year when the grass was green and have come into this price spike in much better shape."

In a similar vein, prices are not so high to fire up Chinese miners into a shovelling frenzy.

The average iron ore content of Chinese mines is around 13 per cent, compared to 62 per cent from the likes of Rio Tinto and BHP.

In other words, Chinese mines have to shift around five times the ground to produce the same content as the Australian mines.

The breakeven price for Chinese mines is said to be around $US80/tonne, compared to sub-$US30 from the Pilbara.

Has the price peaked?

Where the price peaks this time around is open to question, but few observers see it going much higher.

Similarly, few see it plummeting back to the $US40/tonne levels of late 2015, early 2016.

"We don't expect to stay over $100 in perpetuity," Dr Lawcock says.

"$90 a tonne this year looks a little conservative, we have $80 pencilled in for 2020."

Over at CBA, it is a similar forecast, with forecasts iron ore prices transitioning through the $90s and the $80s in time.

Falling demand in the steel-intensive construction sector may limit further upside for the iron ore price. ( Flickr: Tauno Tõhk / 陶诺 )

However, Mr Dhar sounds a note of caution given recent weakness in steel-intensive sectors such as property and manufacturing.

"With margins now low enough to discourage steelmakers to produce steel, we see downside risks to China's steel production and iron ore demand in coming weeks," he said.

"That will likely weigh on iron ore prices and likely push the steel under $US100/tonne."

However, he says another spurt of stimulus from Chinese policymakers could shore up prices at current levels for some time yet.

"$90 by the end of the year and in three years time around $65/tonne," Mr Dhar says, "but that's still a healthy margin for the main producers."

Maybe this time it will be different.

Wall Street retreats after record high

After fairly boisterous week, global markets paused for a bit reflection on Friday.

Wall Street's S&P500 briefly touched a record intraday high, before sliding on anxieties over the increasingly hostile stand-off between the US and Iran.

Markets on Friday's close: ASX SPI 200 futures -0.6pc at 6,651, ASX 200 (Friday's close) -0.3pc at 6,571

ASX SPI 200 futures -0.6pc at 6,651, ASX 200 (Friday's close) -0.3pc at 6,571 AUD: 69.2 US cents, 61.0 euro cents, 54.3 British pence, 74.3 Japanese yen, $NZ1.05

AUD: 69.2 US cents, 61.0 euro cents, 54.3 British pence, 74.3 Japanese yen, $NZ1.05 US: Dow Jones -0.1pc at 26,719 S&P500 -0.1pc at 2,951 NASDAQ -0.2pc at 8,032

US: Dow Jones -0.1pc at 26,719 S&P500 -0.1pc at 2,951 NASDAQ -0.2pc at 8,032 Europe: FTSE -0.2pc at 7,408 DAX -0.1pc at 12,340 EuroStoxx50 flat at 3,467

Europe: FTSE -0.2pc at 7,408 DAX -0.1pc at 12,340 EuroStoxx50 flat at 3,467 Commodities: Brent oil +1.2pc at $US65.20/barrel, Gold +0.8pc at $US1,399/ounce, Iron ore $US118.00/tonne

Over the week, US and European shares rose more than 2 per cent, the ASX a bit less.

Futures markets point to a soft start locally on Monday. The Australian dollar rose a bit, but mainly on expectations of an interest rate cut in the US.

The big mover of the week was oil.

The global Brent crude benchmark put on 5 per cent, while the US-based West Texas Intermediate crude price rose closer to 10 per cent.

G20 meeting trade talks

The prospect of US President Donald Trump and China's President Xi Jinping having a chat about trade off to the sidelines at the G20 summit is about the only notable diary entry for the week.

The last talks in May went badly, ending up with some terse tweets and another round of tariffs and threats to hit everything else coming in from China (another $US375 billion's worth) with a 25 per cent tax.

The world will be hoping it goes better this time; even an amicable non-event would be positive.

Australia

Date Event Comment/forecast Monday 24/06/2019 RBA speech Governor Philip Lowe speaks on "The state of the global economy" Metcash half year result Insights into consumer spending Wednesday 26/06/2019 Engineering starts Q1: Was up a solid 13pc in the previous quarter CSR AGM Likely to provide insights into residential construction Friday 28/06/2019 Private sector credit May: Still very weak, 2.3pc growth YoY

Overseas