The China steel market is pointing to big problems for iron ore

15 May 2017

There is enough iron ore inventory in China’s just now to build 13,000 Eiffel Towers! However, with China’s April PMIs disappointing, suggesting China’s tightening measures is beginning to take hold (that is, demand for steel in China is now weakening), steel supply in China is set to begin to moderate imminently.

To put it another way, this suggests iron ore demand is in the process of waning, which, against a backdrop of near-record iron ore inventories and aggressive domestic and seaborne iron ore supply, paints a nightmarish picture for iron ore prices over the coming months.

On this trend, we would be adding to shorts in Fortescue Metals (FMG) and Rio Tinto (RIO).

When looking at the data, iron ore prices are on the precipice of a “spectacular decline”. China’s iron ore imports were up 11.4 per cent year-on-year to 95.6 million tonnes in March, and so far this year are up 12.2 per cent year-on-year to 271 million tonnes.

In our view, due to what is expected to be a 1-2 per cent fall in year-on-year crude steel production in China in 2017, which is below the 1.04 per cent year-on-year growth seen in 2016, we believe elevated imports in March point to continued inventory build, as well as a lack of seaborne-supply-discipline to falling iron ore prices.

What’s more, moving to the domestic production of iron ore in China this year, it’s clear that momentum is picking up in a very rapid manner (a troubling trend if you’re an iron ore bull).

This year iron ore production is up 21 per cent year-on-year to 45.6 million tonnes. This stellar growth is a by-product of higher prices driven not by fundamentals, but rather the “financialistion” of the futures trading market in bulk commodity materials in China (where traders have to speculate, in the overnight markets, on the daily directional shifts in commodity prices).

Furthermore, moving to the domestic production of iron ore in China this year, it’s clear that momentum is picking up in a very rapid manner (a troubling trend if you’re an iron ore bull). That is, of the 266 domestic Chinese iron ore mines Mysteel tracks, capacity utilisation has risen from 62 per cent as of mid-April 2016, to 69.5 per cent as of mid-April 2017; stated differently, domestic iron ore production is up 21.4 per cent year-on-year to 45.6mt YTD.

Yet, with the cash cost of iron ore production in China at about $US57.80 a tonne, until prices fall below this level we would expect the “rising tide” of supply to continue to be a headache for the iron ore bulls.

In addition, inventories at both the Chinese ports and steel mills are at or near record highs. That is, looking first to major Chinese ports’ iron ore inventories, inventory has increased by 15 per cent so far this year, and is 33 per cent higher than at the same time last year; As we said, there is enough iron ore inventory sitting at the ports in China to construct 13,000 Eiffel towers (that’s a hell of a lot of iron ore).

Moving on to price trends, steel prices in China have been in sharp correction territory for some time now; and, with Cyclone Debbie in Australia pushing coking coal prices higher, steel mill profit margins have deteriorated. This, in turn, caused a shift in approach from the steel mills in China.

Yet, despite these high inventory levels, iron ore prices remain above our $US40 a tonne target for April.

This is mainly because (a) stellar margins for steel mills earlier this year, pushing them to prefer higher-grade iron ore in the face of higher coking coal prices, and (b) the aforementioned preference for higher-grade iron ore, in the face of bloated coking coal prices, enabling elevated production rates at Chinese steel mills.

With the above as a backdrop, as we have warned for some time now, the recent correction in steel prices in China should come as no surprise. Why? With China continuing to pump out record levels of crude steel output, despite an aggressive push by the PBOC to clamp down on property speculation, as well as elevated interbank lending rates (suggesting liquidity has tightened) it seems, currently, supply is outstripping demand … a recipe for disaster.

Source – www.theaustralian.com.au