The Last Secret Left in the Mining Industry

Despite what you read from the financial newsletter industry, there aren't many secrets left in the mining sector...

In the U.S., gold majors like Newmont and AngloGold are widely held and fully valued. Australian mining giant BHP Billiton is now a regular holding of big mutual funds. Most people can look at their electric bill and realize the prices of coal and natural gas have soared in recent years. Share prices of the big coal and natural gas producers have climbed in response.

In other words, after years of commodities climbing in price, everyone wants to own them. That's what makes the story of the Pilbara so amazing...

The Pilbara region of western Australia looks a lot like stretches of Utah... burnt oranges and reds highlighted by spinifex, a bushy grass unique to Australia. But the special thing about this place from an investor's perspective is this: The Pilbara is home to the world's single largest deposit of high-grade iron ore... more than 34,000 million tonnes of it. It's enough to supply the entire world, at current rates of demand, for the next 300 years... and it's enough to turn the Pilbara into ground zero in the world's commodity boom.

For years, big mining companies like BHP and Rio Tinto had a lock on the Pilbara's richest deposits. But not all of them.

The slightly lower-grade ores elsewhere in the Pilbara, or the ones that were simply too far away from BHP's and Rio's existing rail and port networks, were left untouched. Now, though, with contract iron ore prices up 320% since 2003 (by comparison, gold is up "just" 147%), it's a whole different story in the Pilbara.

These days we focus a lot on the importance of energy to our comfortable way of life. But the industrial skeleton on which the infrastructure of a modern economy rests is made of iron and steel. Nations that have it become great. Nations that don't have it will do just about anything to get it.

Right now, China is doing anything to get it.

China has gone from being a net importer of steel to a net exporter in the last six years. According to the China Iron and Steel Association, China produced 151 million tonnes of steel in 2001. This year, China is on track to produce nearly 540 million tonnes of steel, a 205% increase in six years. China is now the world's largest steel producer... with an output over three times larger than No. 2, Japan.

To produce steel, you need iron ore. Australia is home to 16% of the world's iron ore reserves.

China imported 115 million tonnes of Australian iron ore in 2002, 148 million in 2003, and 208 million in 2004. It imported more than 240 million tonnes in 2005, 326 million in 2006, 384 million in 2007, and is on pace to import nearly 453 million tonnes this year. Those imports amount to more than 42% of global iron ore exports.

China needs all that ore to make all that steel because its economy is still rocketing along at 11% growth, according to the latest figures. You can never quite trust government figures, of course. It could be more. It could be less. But either way, it's a lot... and it's making Australian miners a fortune right now.

As we enter 2008, Australia is exporting iron ore, coal, gold, and other commodities to the tune of A$117 billion in earnings, according to the Australian Bureau of Agriculture and Resource Economics (ABARE). ABARE projects export earnings of A$20.2 billion for iron ore producers alone.

Just how big those earnings will actually be depends on the new contract price for iron ore in 2008. Right now, there isn't a new contract price between Aussie ore companies and Chinese steel makers. In late February, China's biggest producer, Baosteel, agreed to a 71% increase with Brazilian ore giant Vale.

But Chinese steel producers are stubbornly holding out against the even bigger increase Aussie producers are asking for. The Australians want at least an 85% increase and want to include a "freight premium" that reflects the lower cost of shipping Aussie ore to China.

The clock is ticking... An 85% increase over last year's contract price of $83.40 a tonne would put the 2008 price at $154.29, about 14% higher than the $132.20 Baosteel agreed to pay Vale. If no agreement is reached by the end of June, Aussie firms are free to sell iron ore in the spot market, where Indian ore has traded between $120 and $150 over the last six months.

This is great news for the Pilbara and its junior iron ore stocks. In fact, the anticipation of higher iron ore prices and Chinese demand has already pushed some iron ore juniors up on the year. The third major player in the Pilbara, Fortescue Metals, is up 60% year-to-date and is a prime buyout target for Chinese investors. Midwest Corporation is up 30% and may soon become the first Australian company to fall to a hostile Chinese takeover.

It's not just big miners like BHP Billiton and Rio Tinto that stand to profit from the bull market in steel. With or without a new contract price by June 30, a whole new gang of junior ore stocks will benefit from a market that just keeps getting bigger... and for investors, better.

Good investing,

Dan Denning