A dramatic Iron ore recovery | Surge linked to energy but driven by a classic short squeeze

Regular readers will be aware that we have been watching developments in the supply and price of iron-ore, the main component of steel production. It is an important commodity for the Australian economy, and is bound up with the fortunes of China, a country that has had an insatiable demand for steel and steel products. Now reports from that country suggest that its government is about to introduce new measures to stimulate its economy.

Recently we wondered if a sharp drop in iron ore prices represented an opportunity for a contrarian trade, against the overwhelming short sentiment that existed: (Is iron ore the deal-of-a-lifetime opportunity | how it might work).

Now iron ore has bounced back, with a vengeance. It is currently about 25% higher than the recent low, which was only earlier this month. Anyone who followed our prescription in the article cited above would now be sitting on a considerable profit. This precipitate rise in iron ore comes at a time when oil is also enjoying resurgence. The chart above shows light, sweet crude for May delivery, which looks like it has decided to have a rest in its upswing prior to crossing the 25-week Exponential Moving Average (EMA).

The rise in the price of iron ore and oil, talk of renewed stimulus from China, all coupled with concerns about a housing bubble in Australia, have combined to make it less likely that the Reserve Bank of Australia (RBA) will lower interest rates. This has had the effect of providing a very decent boost to the value of the Australian dollar.

Iron ore surge linked to energy but driven by a classic short squeeze

The rise in the price of oil and the rebound in iron ore is not a coincidence. Energy is an important cost for iron ore producers, so even the big boys, who have been driving down the price in a bid to increase market share by producing more even in the face of a price drop, need a higher price now in order to maintain profitability. Affecting the price by controlling supply is not a perfect science, but the biggies, Rio Tinto and BHP Billiton of Australia, and Vale of Brazil, are rather good at it. Apart from Billiton announcing reduced production, which they have done, if they wanted a higher price now they have been assisted by cutbacks in output (and near-bankruptcy in some cases) on the part of second tier miners; a surge in demand from Chinese steelmakers, who have started to stockpile in order to take advantage of the fall in prices and, last but not least, the fact that money managers all over the world had bought (literally) into the idea that there was no floor to the iron ore price. They had doubled their short positions between the start of the year and the beginning of this month. With the first flowering of the resurgence in price, they were forced to cover their positions, leading to a rash of buying.

This represents a classic short-squeeze.