Iron Ore: A Bullish Trade Setup

• The ASX to break its recent chains
• A little story with potential momentous significance
• Plus, when to go against the crowd…

Callum Newman

Dear Reader,

Oh my, we are in for an interesting week.

For five months the ASX has traded in a tight range. The [XJO] is only 2% higher than it was in late November.

US stocks just hit new highs again. Can this bullish momentum translate onto the ASX?

I think it will. But the proof will be in the price action today. I’ll be watching all day.

So much will depend on the price of iron ore because it underpins the earnings of BHP and Rio Tinto.

The Australian reports that investment bank UBS is downgrading the outlook for both.

They think iron ore will be back under US$100 a tonne by the end of this year. They see abundant supply coming back from Brazil.

This kind of call is not uncommon in the financial world. There are a couple of points we can make about this.

One is that this is already priced into the iron ore stocks. To what degree it is possible to be 100% certain. But Fortescue was already down nearly 30% the other week.

We can infer that a lot of the damage has been done because UBS value the stock — under the forecast — at $18. It’s about $20 now. Hardly Armageddon.

We also have to wonder exactly whom is behind these calls at UBS.

Anyone who follows the financial press will know that a chunk of their equity analysts ditched the place and joined another firm called Barrenjoey. 

‘To lose one parent, Mr Worthing, may be regarded as a misfortune,’ opined Lady Bracknell to her potential son-in-law (an orphan) in Oscar Wilde’s play The Important of Being Earnest. ‘But to lose both looks like carelessness.’

That’s not to dismiss the opinions and research of the current team. But such a mass exodus is odd, to the say the least.

And then there is the final wild card. It’s called the world. It never sits still. The unexpected turns up with astonishing regularity.

For example, the Australian Financial Review reports that BHP may have a water contamination problem at its Newman mining hub in the Pilbara.

To quote:

‘A source within BHP said the company was bracing for an iron ore production blow if further testing found the contamination was above acceptable limits and had the potential to spread through the water table as a result of mine de-watering operations.’

Now this is vital to watch. BHP was on track to produce more than 250 million tonnes of iron ore for the financial year. That’s second only to Rio.

Any sustained problem for the second producer in Australia — the biggest iron ore exporter — is unlikely to leave the price unaffected.

Watch this space.

We then have the curious case of the forgotten iron ore project Australian Premium Iron (API) potentially coming back.

The Australian Financial Review reports that the project was iced after the iron ore price declined after 2013. There are three key owners of the project from China, Korea, and the US.

Why would they bother with API if they did not see sustained higher prices or higher inventories as a solution to the demand out there?

Granted, they wouldn’t be the first set of investors to give the go ahead to a project at the top of the market. But the scale of the original API project was $7 billion. That’s big.

There are much cheaper and more modest projects to get your foot into the booming market than trying to life a giant off the mat.

We are all subject to Mother Market. Only she can tell us whether I’m wasting my — and your — time expecting money to be made in iron ore stocks against expectations.

But even if I’m wrong I won’t regret it. It’s not often you find cause to be bullish against the crowd. This is where the best trades can spring from, because the upside far outweighs the downside.

That means you can position for iron ore to hold steady — or even lift — and it happens the stock should rerate because such an outcome is not built into current prices.

And if UBS is right? Well, that’s mostly priced in anyway. You take a small hit and move on to other ideas.

We’ll see. Right now watch that water contamination issue at BHP. It might sneak up on the unwary.

Regards,

Callum Newman,
Editor, The Daily Reckoning Australia