Learnings from the iron ore price shock

The massive drop in iron ore prices has seemingly caught everyone by surprise and firm expectations of about 1.1 billion tonnes of crude steel production from China now seem unlikely. Given value creation in the resources industry is heavily influenced by the navigation of cycles, understanding these miscalculations is very useful.

Our view is that three failings contributed significantly to this surprise:

1. Forecasts seemed improbably against simple top down review

Japanese development peaked at ~ 110Mtpa of steel. China has just over 10 times the population of Japan, so 1.1 billion tonnes of production is equivalent to a Japanese style boom happening simultaneously across all of China. While possible, this stretches the bounds of probability given China’s size and diversity.

2. The resolve of all suppliers to bring on tonnes was underestimated

When analysing 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.

3. Cost curve inflation was accepted as largely permanent

In calculating price, costs that had increased massively (> 100% in less than a decade) were often used. The probability that costs would deflate substantially with prices as the market moved into oversupply was not willingly accepted.
Had these factors been considered in forecasting calculations, the current price scenario may not have been the surprise it has been. So why weren’t they? The answer lies in something much more complex – human biases driven by a broad rejection of uncertainty, incentives and a tendency to anchor in the current.

 

Graeme Stanway

Graeme Stanway

Graeme Stanway is a partner of VCI Ltd, a global strategy design company. Graeme has over 20 years’ experience in mining, heavy industry and technology businesses. He holds a PhD from Imperial College University of London, has been awarded the Medal of Innovation from the Institution of Civil Engineers in the UK. His strategy work has been referenced in the book “The First 11” as a benchmark case study in strategic transformation.