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New freight fuel rules give edge to Australian iron ore

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BHP Group has effectively confirmed that the 2020 introduction of new global emissions standards for shipping fleets will enhance the competitiveness and potentially the financial returns of Australia’s ebullient iron ore industry.

In a blog to be published on its Prospects website on Thursday morning, BHP has estimated that the expense of retro-fitting of ships and higher fuel costs will add between $US2 to $US3 a tonne to the price of shipping iron ore from the Pilbara to China.

But BHP reckons that the new International Maritime Organisation (IMO) regime, which bans the use of the high sulphur bunker oils that are presently the standard fuel across the shipping industry, will add between $US3 to $US5 a tonne to shipments from Brazil.

BHP’s vice president of market freight, Rashpal Bhatti, introduces his cost forecasts with the observation that “if the shipping industry were a country, it would be the sixth largest emitter of CO2 on the planet”.

The new IMO rules, that will come into effect from January 1 next year, require an 80 per cent reduction in sulphur emissions. Achieving that mark will be a cat killed many ways, from adding scrubbers to exhaust systems to embracing fuels new to shipping like liquefied natural gas, biofuels blends and eventually possibly hydrogen.

LNG a shipping fuel of the future?

Woodside and the likes of potential east coast LNG importer, Australian Industrial Energy, are well advanced in planning for the need for the bunkering and break-bulk facilities that might be needed to meet future demands by freighters ploughing the Australian coastline.

It should be noted that the bands of cost increases estimated by BHP’s vice president of market freight, Rashpal Bhatti, sit slightly more cautious than the range predicted last month by leading independent resources industry analysts, Wood Mackenzie.

WoodMac has estimated that the greater distances travelled by Brazilian vessels headed to China will see freight costs rise by more than 40 per cent or $US6 a tonne. For Australian and Indonesia bulk commodity exporters WoodMac estimated prices would rise between $US1.70 and $2.90 a tonne.

But, while the numbers are different, the thematic is the same. The already material freight differential that advantages Australian iron ore exporters is going to expand.

The importance of the differing cost effects on Australian and Brazilian producers is that now legendary market reforms that BHP forced the iron ore sector to embrace back in 2010 mean that the lower cost export has been able to pocket any freight differential.

The epicentre of seaborne trade shifts

In changing the way iron ore is priced, BHP and its belated ally, Vale, did a whole lot more than replace the decades-old annual price fix of shipments of contracted volumes with a set of shorter-term mechanisms that were based on an index price that better reflected the dynamics of an under-supplied and volatile market.

First and foremost, the reforms confirmed a critical shift in the epicentre of demand for Australia’s bulk commodities.

From the mid-1960s until the early years of this century, the Japanese steel mills (JSM) and their collective interests drove the pricing of Australian iron ore and coal.

But 40 years of sometimes slightly unequal interdependence with the JSM was swept away within just a few years of China reaching into the seaborne bulks trade to meet its rapidly growing domestic needs.

BHP’s successful promotion of the need for index-based pricing delivered the producers with a clear line of sight on the real clearing market price of iron ore. The market was suddenly being set by the highest cost marginal tonne of production in the system. The real world effect of that was that the highest cost production in China became the price setter for the whole market.

That delivered the price signal necessary to encourage the seaborne operators to build out their systems to cope with a market in rapid progress to more than doubling in size. And it provided the Chinese producers with every incentive to allow free and open trade in raw materials in the name of the mean reversion that eventually occurred.

The other thing that BHP achieved was that the landed Chinese price became a standard for the new iron ore indexes. As a result, the cost of freight is baked into reference prices and Australian producers are able to harvest their freight cost advantage.

Just for the record, as of last Friday it cost $US7.31 a tonne to ship iron ore from Western Australia to China while it cost $US17.14 a tonne to move tonnes from Vale’s ports on Brazil’s eastern coast to the world’s biggest iron ore market.

Just as a point of further interest, the change in energy diets for the big and very big ships is expected to intensify demand pressures for diesel fuels and that is going to have some effect on overall mining costs.

WoodMac has forecast that diesel prices will add US27 cents a tonne (or 1.3 per cent) to average freight on board costs for iron ore miners.

“However, the impact will not be evenly spread. Mines that use trucking for long-distance transport, have diesel-fired power generation, or have a high ratio of material moved to marketable production will be affected most,” WoodMac predicted.

"On thermal coal, Indonesia, the world's largest thermal coal exporter, will see a larger cost increase compared to Australia, the second largest exporter of thermal coal. This is because Indonesian mines almost exclusively use diesel-powered mining equipment, have long truck hauls to barge ports, and utilise diesel-powered barges for river-based transport. Australia, on the other hand, has a higher proportion of electrified mining equipment and conveyors."

Not all good news

Now, less we risk being lured budgie-like to the shiny positives, it has to be acknowledges that, whatever the additional national advantage that Australia might draw from the 860 million tonnes a year of iron ore it exports every year, it will only go some way to mitigating the cost hikes that the IMO reforms will bring to our import economy.

As colleague Angela Macdonald-Smith reported back in May, the boffins at WoodMac predicts somewhat counter-intuitively that the IMO’s new rules will flow through to lower liquid natural gas prices.

Meanwhile shipping companies have warned that the higher fuel costs generated by the demands of IMO2020 will be passed through to consumers in what the Australian Peak Shippers Association has warned “will be one of the largest cost recovery exercises that Australian importers and exporters will face in the coming years”.

Now, while we are talking BHP and exports, the thinking Australians have confirmed that it is working to effectively trim production from the last of the pure thermal coal operations that it operates.

This is a project of two missions. As The Australian Financial Review reported on Wednesday, the move to upgrade the quality of production at the Mt Arthur mine is aimed at inviting more interest from Japanese utilities to mitigate the market risk revealed by China’s unofficial “bans” on Australian coal imports.

More than just de-risking China

Washing more coal to increase its calorific count will add to the cost, increase recovered prices and reduce production volumes. And I would posit that there is another even more topical motivation for BHP to contemplate an outcome that reduces Mt Arthur’s production with any level of revenue or cash flow neutrality.

BHP has been in extended conversation with Norway’s sovereign wealth fund over the new ceiling it has put on investments in miners that produce 20 million tonnes a year or more of thermal coal.

Mt Arthur generally produces about 18-19 million tonnes annually and BHP produces about 1mtpa as a by-product of its suite of metallurgical coal mines in Queensland. Now, Norges is one of BHP’s bigger and more enduring long owners and the miner has been in deep conversation with the fund over how it might limbo under its raised divestment bar.

So an up-grading option that might leave BHP comfortably shy of the Norwegian’s emissions cap makes even more sense of a plan fathered by the need to diversify market risk.

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