The massive drop in iron ore prices has seemingly caught everyone by surprise and it now seems unlikely that China will produce the 1.1 billion tonnes of crude steel previously estimated. Understanding these kinds of miscalculations is important, particularly given how important the navigation of cycles is in resource industries.
Here are the three key failings that led to this unwelcome surprise:
1. Forecasts didn’t stand up to even the simplest review
When we look at Japan’s production, it peaked at ~110Mtpa of steel. China has just over 10 times the population of Japan, so 1.1 billion tonnes of production would have been equivalent to a Japanese style boom happening simultaneously across all of China. While possible, this stretches the bounds of probability, particularly given China’s size and diversity.
- 2. Suppliers’ resolve to bring on tonnes was underestimated
When analyzing potential oversupply, high cost developers often assumed that others would pull back on their expansions, even though they had no intention of doing so themselves. It seems the ‘tragedy of the commons’ is alive and well in the iron ore industry. Individual suppliers acted in their own self-interest, but underestimated other suppliers’ willingness to do that as well.
3.Inflation was accepted as largely permanent
In calculating price, costs that had increased massively (>100% in less than a decade) were often used. It was not willingly accepted that costs could deflate substantially with prices, even as the market moved to oversupply.
Had these factors been considered in forecasting calculations, the current price scenario may not have been the the surprise it has been. So why weren’t they? The mining industry has not yet embraced the kind of predictive analytics that can help forecast in a more accurate, real time way. Until it does, complex human biases will continue to create oversupply denial and promote human tendency to anchor in the current.
Instead, resource industries need to be much more tightly aligned with the market current-a strategy that will help them stay competitive and get in front of the big pricing drops and other margin –stealing surprises.
Graeme Stanway, Partner VCI