Will iron ore crash to new lows?

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The SMH has a good story from Reuters this afternoon on the iron ore rout:

The root cause of the current weakness in the iron ore market is the same as the last time around, namely margin compression in China’s steel sector.

The tension between a previously largely steady iron ore price and falling steel prices has been building for several weeks.

…Of course one of the main reasons for weak Chinese steel prices is too much production relative to demand.

And what is curious about the current dynamic in China is that steel production itself shows no signs of slowing.

National output in April was running close to 800 million tonnes annualised, just a shade below February’s all-time record run rate of 806 million tonnes.

The higher-frequency figures from the China Iron and Steel Association (CISA) suggest that output may have actually accelerated further in the first part of May with only the most marginal of slowdowns in the middle part of the month.

Quite evidently this is unsustainable. That’s what falling Chinese steel prices are telling us.

But equally evidently there is a collective reluctance to cut run rates with China’s legion of smaller mills in particular reluctant to forfeit share of a market still characterised by eternal optimism.

The story goes on to draw differences with last year’s crash:

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Annualised steel production was already falling in July 2012 and it slumped by a massive 35 per cent to 691 million tonnes in the month of August itself.

High inventory and falling prices of steel products at one end of the chain fed back up through steel production cuts to a vicious iron ore destock at the other end.

This time around, though, the steel sector appears to be embarking on a pre-emptive rather than reactive iron ore destock.

Given that record amounts of steel are still being churned out, it is a moot point as to just how much more raw material can be destocked.

…Macquarie Bank agrees, arguing that “the need for Chinese mills to restock can absorb” both a mid-year slowdown in steel production and the additional Australian supply expected in the second half.

“The iron ore clear-out happening now reduces the potential for a collapse in H2,” it notes, cautioning that “iron ore could surprise relative to expectations” (“The 10 key things to know about current metals and mining markets”: May 28).

A pretty perverse argument, this. We should be glad because the iron price is falling now instead of later. Anyway, readers will know that I have myself been attracted to the grind lower argument owing to a lack of Chinese port stocks. It is not unreasonable and frankly I would be surprised if iron ore went to last year’s lows on this move (though later is inevitable).

But the reasoning has a problem in this environment. If things are so dire in Chinese steel margins, no matter how hard mills try to avoid it, production is going to have to be cut. That means lower ore demand for a period just as it did last year and means iron ore could still fall sharply from here even with lower inventories. That is, I suspect, what is beginning now.

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Moreover, when the restock does come, I sincerely doubt that the mills will repeat the mistake they’ve just made and stockpile like crazy. The fall will hopefully be smaller this time around but the rebound will likely be smaller too.

Rebar futures are down another 1% today.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.