Is iron ore a deal-of-a-lifetime opportunity? | How it might work

For a little while now we have been watching the iron ore story, mainly as a potential factor in the rise and fall of the Australian dollar. Iron ore has been a vitally important part of the economy of Australia for many years. Recently, the price of this commodity has been going through the floor. This process started with a slowdown in Chinese infrastructural development, which led to a reduction in demand for the raw material of steel production. China manufactures more steel than the rest of the world combined. However, instead of reducing mining output in the face of this downturn, the three largest global iron ore producers, Vale of Brazil and Rio Tinto and BHP Billiton of Australia, actually increased production. They have significant economies of scale, and this strategy is seen as a means of reducing the level of competition in the iron ore marketplace. It seems to be working, as a number of mid-tier Australian miners have either had their shares suspended or shown other signs of feeling the pinch.

There are iron ore producers in China, too. These are seen as small and high-cost, and therefore also potentially at risk from the fall in price. However, there are now signs that the Chinese government will come to their aid, with state or local government financial assistance. That should cause the larger non-Chinese miners some pause for thought.

And then there is India. That sub-continent has made known its intention to increase its output of steel by a factor of three over the next few years. Also, the US economy has turned the corner after the global financial crisis and steel requirements there, particularly for the automotive industry, are set to increase. So the demand for steel, and therefore for iron ore, might be set to stage a turnabout in the not-too-distant future.

And now there is yet another element in the mix. A report from Reuters has pointed to the really significant increase in futures and options short positions in iron ore (“Speculators jump on bearish iron ore bandwagon”). Could this be setting up a classic opportunity for taking advantage of the short squeeze that would be on the cards should the price of iron ore suddenly turn to the upside, and all these speculators have to cover their positions by buying iron ore commodity futures.

How it might work

One might like to proceed in the manner of the legendary Jim Rogers, who in 1980 believed he saw a somewhat similar opportunity in gold. We reproduce this from Investopedia.com:

Rogers - and his famous short trade in gold - is well worth examining in more detail. In 1980, when gold spiked to record highs on the back of double-digit inflation and geopolitical unrest, Rogers became convinced that market for the yellow metal was becoming manic. He knew that like all parabolic markets, the rise in gold could not continue indefinitely. Unfortunately, as is so often the case with Rogers, he was early to the trade. He shorted gold at around $675 an ounce while the precious metal continued to rise all the way to $800. Most traders would not have been able to withstand such adverse price movement in their position, but Rogers - an astute student of the markets - knew that history was on his side and managed not only to hold on, but also to profit, eventually covering the short near $400 an ounce.

Aside from his keen analytics and a steely resolve, what was the key to Rogers' success? He used no leverage in his trade. By not employing margin, Rogers never put himself at the mercy of the market and could therefore liquidate his position when he chose to do so rather than when a margin call forced him out of the trade. By not employing leverage on his position, Rogers was not only able to stay in the trade but he was also able to add to it at higher levels, creating a better overall blended price.

Or take the example of John Paulson, who decided in 2006 that the US residential property market’s reliance on sub-prime mortgages was unsustainable, and managed to convince counterparties to enter into Credit Default Swaps (CDFs) on specific sub-prime mortgage debt with him, so that when the collapse finally arrived he profited to the tune of many Billions of dollars. This fascinating story is told in Gregory Zuckerman’s book, The Greatest Trade Ever, How John Paulson Bet Against the markets and Made $20 Billion.  

Is iron ore the next gold mania or the next sub-prime mortgage bubble, but on the downside?