China, Iron Ore and a Future Bust

“The numerous misfortunes, which attend all conditions forbids us to grow insolent upon our present enjoyments… For the uncertain future is yet to come, with every possible variety of fortune.” 

– Solon’s Warning

CONTEXT: 

I am one of the very few Aussies who is concerned about the future of an industry, iron ore exports; which represent a large portion of Australia’s GDP. From a fundamental top-down perspective I concur with the Hugh Hendry/Jim Chanos observation that China is amidst a credit bubble and is running an unsustainable economic model. The Chinese steel sector would be unprofitable in 2012 based on Chanos’ forecasts, yet they continue to add more and more capacity to a decentralised steel sector which is directed by local municipal government employees so they can meet their GDP targets.

From Barrons (emboldened emphasis mine):

“China has an investment-driven model where they simply want to produce GDP growth. They can continue showing GDP growth, as long as there is credit to support that investment. The problem is that most of these investments, at this point, do not generate an economic return and haven’t for a while. So you have the dichotomy of a country growing its GDP but destroying wealth. I view it as a stock that’s rapidly growing, but whose earnings are below its cost of capital. Any finance professor would tell you that’s a company that is liquidating and going to run into the wall. That’s what China is doing. But it can go on for a while.”

Essentially, China responded to the financial crisis with a massive stimulus via credit expansion in 2009.  From a historical standpoint, this was the single largest monetary expansion as a percentage of GDP ever undertaken.

CHINA M1:

China M1

CHINA M2:

China M2

With the CCP’s politburo aggressively directing the economy from on high and trying to stimulate growth via incentivising construction, massive overcapacity was inevitable.  Most notable examples: construction (property developers, cement makers), steelmakers (steel companies, iron ore miners, coking coal miners), shipping (ship builders) – all suitable industries to be short when the timing is right. This view is my fundamental bias, albeit I am agnostic to timing.

Below are a couple of videos on the Chinese real estate over-construction/overcapacity problem, the first which aired on Dateline in 2011 gives some insight into the idle-capacity which represents the liabilities side of China’s balance sheet, the second by Stratfor gives a more recent look at the policy implications and the difficulty the CCP are having in maintaining growth, whilst increasing the standard of living and attempting to convert from a investment-led growth model to a consumption-led one.

In order to monitor the fundamentals on the ground in China there are two main considerations, 1) policy (which I will be monitoring going forwards) and; 2) Shanghai rebar (short for reinforcing steel) is essentially the secondary market of iron ore and is the best proxy to Chinese domestic demand.

SHANGHAI REBAR INVENTORY:

Shanghai Rebar Inventory

SHANGHAI REBAR PRICE:

Shanghai Rebar Price

IRON ORE:

Iron Ore

Today, iron ore prices are reflecting the positively bullish assessment of global growth (read Chinese) demonstrated by equity markets. Early last year I spoke with World Steel Dynamics, who reinforced my bearish bias with a view based on their brilliant research that Iron Ore would sell off by July and they were very nearly correct with timing and their target price level. So I will look to discuss with them again in the near future what their views are for 2013.

From the information we do have however, we can see that Iron Ore is leading rebar, this divergence would (normally) encourage me to look for an entry to be short once rebar falls over, however, 93 mines have been shut down in India due judicial activism which may have contributed to short-term supply constraints.

Shanghair rebar and Iron Ore

CORRELATION – Iron Ore & Shanghai Rebar:

Iron ore and Shanghai rebar are usually fairly tightly correlated as we can see below, yet they have diverged to the 99.59th percentile over the last 12 months’ spread – perhaps this is due to a disparity between on the ground demand in China and iron ore prices reacting to a supply squeeze out of India?

Shanghai Rebar Iron Ore Correlation

All things being equal, I anticipate a continued short-term global economic rally, however, one thing we can be certain of is that the underlying reality will again rear its ugly head and demonstrate that Iron Ore demand is not as significant as many companies have bet. The largest bet by an Iron Ore producer on this demand is that of FMG with a total debt to equity ratio for FY2012 of 2.26x.

FMG’s expansion plans have eclipsed targets of 95Mtpa for FY2013, with an annualised Dec12 run rate forecasting a possible 100Mtpa, with an ultimate target of 155Mtpa.

CORRELATION – FMG & Iron Ore:

FMG and Iron Ore are very tightly correlated at the moment, given FMG’s highly levered bet on the price of Iron Ore, its fate is invariably sealed to the price staying above $90/t for the next 2 years (I will get to this in my next post) – making the future of FMG very binary.

Correlation Iron Ore FMG

TECHNICAL ANALYSIS: 

FMG is in a long term down trend since it hit a post financial crisis high in January 2011, the key resistance line since that time is drawn in below and FMG has continued to sell off on approach to this trend line. However, given Iron Ore prices are nearing $150/t and FMG is running a potential 100Mtpa, one must assume FMG’s equity price will advance on Iron Ore prices at this level and break out through this trend line.

FMG trendline

FMG is testing some very important price levels at $5.04 which is a key resistance level, I suspect it will roll over slightly from here and bounce off support at $4.67 to rally and break out through the resistance at $5.04. Thereafter, $5.50 and $6 are the key resistance levels. Between these price levels I anticipate FMG’s price action to encounter resistance, at which point I will look to pull the trigger on my bearish positions: short the equity and long OTM puts at previous key price levels of $3.50 and $4. 

FMG resistance breakout

FMG IMPLIED VOLATILITY:

Implied volatility, which is the market’s best estimation of future price volatility and hence an input into option price models; often falls during rallies, which provides an opportunity to take an option position with an increased probability of making a profit. Nb. the longer the timeframe the higher the likelihood volatility will mean revert. In this case I will look to pull the trigger on the put positions with different tenors (I hope to outline for you in the future) as well as a buy a long-dated strangle, to express a view on FMGs binary future, as well as to take advantage of the flaws in normal distributions – an inability to accurately gauge the probability of future price trends that are deemed improbable by the pricing model.

Implied volatility is a key caveat when I enter options positions, if implied vol is high (which I like to think of as a price) it means I am paying more for my options, and less likely to expire in the money from a probabilistic standpoint. Typically I like to buy volatility in the quantiles, near long-term lows – areas where I am comfortable the Implied is near a floor. If we look at implied volatility below, we can see it is heading towards April 2012’s lows in the low 30’s – remember, low volatility is the single best predictor of higher future volatility.

Implied Vol

Implied Skew Steepness

EXPLOITING OPTIONS MODELS:

A normal distribution, the mathematical basis for options pricing models imply future prices are more likely to be near the current level, while probabilities decrease significantly for prices further OTM from current levels.

Standard_deviation_diagram.svg

However, I think the reality for FMG is a fairly bimodal distribution, something more like this:

bimodal

If this is the case, regardless of my bearish view on FMG’s future, we can de-risk our directional view, expend a small amount of premium and buy a long-dated strangle – this position could have some potentially large upside when FMG’s price moves to acknowledge that Forrest/Power have either succeeded or failed… We will find out in the next 9-18 months.
In the meantime lets keep our fingers crossed FMG’s Implied Volatility falls and it rallies to $6, so we can make the bet!

Enjoy your weekend,

Carl

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