View from Crystal Bay: Shooting for the Stars

Investors aren’t limited to only investing in the S&P 500 and the Dow Jones Industrial Average. Every week we share the market trends we are following. We are interested in whether the trends in those markets are continuing or if they are experiencing a temporary or complete reversal.

When we identify trends, we are only concerned about the price data and what it says about any given market. We don’t need to know why a trend has formed to invest, but our human nature wants to understand what is driving them. Each week we try to offer some perspective on what we think the most substantial moves are and what critical drivers are behind them. Here we look at what is going in our globally diversified, non-correlated Crystal Bay Ubitrend strategy.

Last week’s continuing trends:

  • Soybeans
  • Soybean Meal
  • Palm Oil
  • Russel 2000 Index
  • Sugar

Last week’s reversing trends:

  • Aluminum
  • German Bunds
  • UK Bonds
  • The New Zealand Dollar
  • The Japanese Yen

What we are taking note of: 

Stars are like people: they are born, grow old, and die. A cloud of gas and dust starts collapsing until it compresses and heats up to the point where the fusion reaction ignites. The reaction consumes hydrogen, helium, and other elements of the periodic table all the way up to iron. Once the star makes too much iron, it dies. Iron is the ashes of stars.

Iron Ore Futures – Since January 1, 2020

The universe is over 10 billion years old. Generations and generations of stars have been born, burned brightly, and died. They left behind an abundance of iron, making it the 9th most common element in the Solar system and the 4th most common element in Earth’s crust.

Unfortunately for iron, another common element on Earth is oxygen. Highly reactive, it turns iron to rust. Iron cannot survive for long on Earth: the only naturally occurring pure iron rocks are meteorites. It took mankind millennia of effort to discover how to turn iron ore (which is mostly rust) back to iron and later to steel. But now we live in the Iron Age, or perhaps the Steel Age. No other material is as essential to our industrial civilization as iron. The global economy uses over 2 billion metric tons of iron ore every year. 

Thanks to iron’s abundance, iron ore mining is a very different business from mining other metals. Gold or copper miners spend years searching for deposits and building complex processing facilities to extract the metal from the ore. Iron ore miners do none of that. There are plenty of iron ore deposits with 60% or more iron content. All that is needed is to scoop it up and feed it directly into a blast furnace. The challenge becomes logistics. Iron ore is a low value, high volume commodity; getting it cheaply to market is the most important task for a miner. Global trade in iron ore is dominated by two countries, Australia and Brazil, which share over 70% of the market between the two of them. Both have large deposits conveniently close to good harbors, and both have built excellent rail infrastructure that keeps their transport costs down. If there is even one hill between the deposit and the port, the whole operation may become uneconomic.

If the producers of iron ore are concentrated, the buyers are even more so. A single country, China, consumes 70% of global iron ore. Its dramatic transformation from a starving basket case to a modern juggernaut created an insatiable appetite for steel as it builds out its infrastructure and consumer markets.

Iron ore pricing used to be an opaque affair, negotiated in smoke-filled rooms in Japan and Australia. That is starting to change with the emergence of transparent futures markets in iron ore during the past ten years. There are two major venues trading iron ore futures. The first is the Dalian Commodity Exchange in China, with 95% of the total volume. The second is the Singapore Exchange, with 5% of the total volume. Both trade benchmark futures for delivery in China. Chicago Mercantile Exchange’s efforts to compete with them haven’t gotten off the ground; the US is not an important producer or consumer of iron ore.

Iron ore prices have become a proxy for exposure to Chinese industrial activity. Foreign investors are concerned about the reliability and truthfulness of Chinese corporate accounting, and some of them are turning to iron ore futures to benefit from Chinese growth directly. Their prices have been telling a story of remarkable strength in industrial activity in China in 2020. Steel production is growing over 10% year over year, compared to single-digit declines in Europe and the US.

And while demand thrives, supply is reeling from shocks. A landslide at a large Brazilian mine in the middle of December shut down the operation for a week. The mine is near a tailings dam collapse, which killed over 200 people in 2019. Both operations are run by Vale, a company holding 20% global market share in iron ore. Calls for stricter safety standards are growing understandably louder, and Vale may be forced to refurbish its operations; it certainly won’t be able to expand much in the near term.

Like the laws of physics that determine the fate of stars, the laws of supply and demand are universal and merciless. Growing demand and shrinking supply lead to higher prices. Iron, the ashes of stars, obeys both sets of laws.