China’s great iron ore pile

I won’t lie, the iron ore price has been making a goose of me for almost two years. At various points my forecast for big falls has almost been right but in total I have been clearly wrong. My prediction has been frustrated by tear away fixed asset investment in China, new market dynamics and Indian ore export bans. But there are some worrying signs that iron ore is looking rather toppy again now. The recent week has seen a little bounce but on the longer term chart, spot prices are approaching trend support:

Moreover, there appear to be big forces at work on the demand side. Back in February, China’s Iron & Steel Association (CISA) announced it was studying plans to create a strategic reserve of iron ore:

China will study plans to create reserves this year for iron ore and coal as national strategic resources, the China Iron & Steel Association (CISA) said.

As the world’s top buyer, China will invest more in iron ore mines overseas in a move to reduce its heavy reliance on imports from global iron ore miners Rio Tinto Ltd, Vale and BHP Billiton Ltd, it said.

“China should change its vast foreign exchange reserves into state reserves of resources that we rarely have but badly need,” Luo Bingsheng, who this month stepped down as vice-chairman of CISA and is now a special advisor for the association, said.

The idea clearly has merit for the Chinese in their interminable battle with big Australian miners and the push towards a floating market or spot pricing for iron ore. A strategic reserve of sufficient magnitude creates a new price-making pressure point on the demand side of the equation because it consolidates the power of many disparate steel makers into the hands of whoever it is that controls the reserve. That is not to say that it marginalises supply and demand forces, but it does certainly add a new weapon to the demand side in negotiations.

For example, you may recall that CISA used to represent the majority of Chinese steel makers in negotiations over annual ore pricing contracts with BHP and Rio. However, during the big price spikes (in the spot market) in 2008, the Australian miners pushed trough very high contract price rises (and tried to merge to further consolidate their negotiating power). When the spot market collapsed during the GFC, many Chinese mills walked way from their contracts and instead bought ore more cheaply on the spot market. However, as prices recovered, the annual contract violations of the Chinese gave BHP and Rio the moral high ground to push through shorter term contracts, which now reflected the rising spot prices more quickly. Chinese steel-makers were effectively splintered, the annual contract system that provided discounts was broken, and BHP and Rio made hay.

A strategic reserve helps restore some of the former concentration in buying power because it might, for instance, be run down at times when contract negotiations or market pricing runs too hot. Put simply, once in place, a strategic reserve is a new source of supply controlled by those on the demand side and can weigh permanently on prices.

Now, I’ve seen nothing about CISA or anyone else actually acting on the building of this reserve since the idea was mooted. But let’s take a look at what’s happened to Chinese port inventories of iron ore in the past year:

And compare that with the last five years:

Since 2008, inventories have more than doubled. I don’t want to sound too conspiratorial. This is probably all natural causes, just a steady build of supplies. The latest climb is so steep it rather looks like a statistical revision. Also, China did increase steel production between 2009 and 2010 by 9.3% and by roughly 25% since 2007. If that doesn’t quite seem to account for it, we might finger hoarding or just slower than anticipated demand. Any input into these ideas is welcome.

Whatever it is, it has some analysts speculating that the iron ore glut is coming sooner than the 2014 timeline that is gospel in Australia. From Forbes today:

As China builds its inventories and global production rises from heavyweights like Vale, Rio Tinto and BHP Billiton, we expect average prices for iron ore to drop off in the coming years. If these prices drop more than we expect, there could be downside risk to our $42 price estimate for Vale, which is roughly 30% ahead of market price.

The ferrous minerals division, which accounts for 63% of the company’s value, is by far the most valuable division for the company. Currently, more than 75% of the company’s profits come from this division. This division includes vale’s iron ore, iron ore pellet, pig iron, manganese and ferroalloys shipments, with China being its largest consumer with 60% market share.

We expect the iron ore prices to fall by approximately 30% in 2011 and 9% the next year, after which, prices may settle down at around $100/ton levels. This could weigh on company’s stock price.

Over Supply Concerns

The continuous build up of iron ore inventories in China, the world?s largest producer and importer of iron ore, over the past few years will help it reduce its reliance on external iron ore and price shocks. Also the three largest iron ore miners globally Vale, BHP Billiton and Rio Tinto are investing heavily in expanding their mining production to meet anticipated demand from emerging markets.

In addition, the announcement by the Chinese Ministry of Land and Resources to invest CNY 30 billion in ore seeking tasks beginning 2011 will also contribute to oversupply in the iron ore market by 2012.

As impressive as 30 billion yuan is, it can hardly boost ore supply in one year (see Troy McClure for more criticism of this article). Moreover, as Phat Dragon argued yesterday, China’s program of fixed-asset expansion is nowhere near done. Longer term, demand looks likely to remain strong and, even if prices fall, volumes shouldn’t.

However, what is plausible is that as China continues to tighten monetary policy and as the world economy slows, we might see an iron ore inventory cycle, either deliberately or as a part of natural slowdown, that is exacerbated by the gigantic pile of red metal sitting in China’s ports.

That is a scenario in which we might see $100 iron this year.

This is all quite speculative I realise but if someone can throw more light on the provenance of that inventory pile, I’m all ears.

Houses and Holes
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  1. If the chart showing stock at Chinese ports was re-jigged as a rolling % of annual imports I think this would be put into context.

    Such is the dominance of the big 3 that China’s efforts to diversify supply by acquiring reserves, entering into JVs etc are really small potatoes compared to the size of their annual imports. And in any case the timeline for bring a lot of those reserves online is similar or longer than the expansion planned by the big 3.

    So I see no reason to depart from a mid-decade timeline for supply outstripping demand.

  2. “As the world’s top buyer, China will invest more in iron ore mines overseas in a move to reduce its heavy reliance on imports from global iron ore miners Rio Tinto Ltd, Vale and BHP Billiton Ltd, it said.”

    Like i said before, time to buy some SDL? Apart from getting iron ore from BHP, RIO, FMG, Vale it’s really the only one that makes alot of sense. Fund the plant and equipment needed for all stages of production and export for a very nice offtake agreement.

  3. Periodically oversupply occurs.

    The build-up of inventories is in reality multifactored: strategic, price anticipation, weakened demand, anticipated increased demand – really take your pick. And yes, the Chinese are endeavouring to strategically regain influence in ore pricing. Makes sense. May 2011 saw record levels of steel production from China. The analysis of the current build-up below would appear as valid as any other at present – building inventories looking ahead to continued record steel output. Chinese building of rail, harbours, ports, bridges, tunnels, terminals etc is in no way complete. It’s not just apartment building.

    “Chinese iron ore, chrome ore and ferrochrom buyers are building inventories ahead of well-publicized power-driven summer production cuts. China consumes up to 50 per cent of key global commodities and materials such as iron ore, chrome ore, steel and coal.”

    Bulk cargo:

    And lastly something we all do from time to time:

    My current response to all matters concerning China, now that the collapse meme has taken hold, is don’t worry, be happy, business as usual – until it isn’t.

    But I wouldn’t quite take to Treasury’s extreme!

    • MontagueCapulet

      “Chinese building of rail, harbours, ports, bridges, tunnels, terminals etc is in no way complete”

      Obviously. They’ll still be building bridges 1000 years fron now. But what matters is the RATE they build infrastructure. The current high prices are a result of an accelerating demand for steel. If demand levels off, but remains high, supply will come into balance within a few years and prices for iron ore will plummet.

      You see a lot of discussion along the lines of “the Chinese are going to build X million miles of railway, therefore prices will remain high”. But if they build an enormous amount of infrastructure in 2014, but it’s no more than they built in 2012 or 2011, you’d expect prices to fall as supply catches up with demand.

      It even possible, and I know this is hard to get your head around, that China may build an enormous amount of infructure in 2014 but this amount would actually be slightly less than they built in 2011. In which case prices for raw materials would nose-dive. There’s no iron law that says their build-out rate must increase every year just because they still have 400 million peasants waiting to urbanise. The urbanisation could continue, but at a more moderate pace which sees a lower annual demand for iron and coal than we currently experience.

      • Thanks – I think I can get my head around it!

        It is my view that the current ore pricing levels are just that – current. Aside from a major calamity, my best guess would be a couple more years of good but not historical pricing and if we’re lucky, a couple more. But really that is chrystal-ball gazing (obviously Treasury has one). Given global slowing, demand for steel may level off and eventually new mines will come into production (although the timing for these could be problematic).

        My 2c. Cheers.

          • I’m hoping for a similar chart to Nasdaq 2000-2002.

            Mate, that iron ore chart just screams !!BUBBLE!!

            But don’t worry, Australia is shutting down the rest of the economy and investing everything in the bubble.

            Its kinda like if the US shutdown its entire economy, and invested everything in Yahoo! stock in late 1999.

          • It’s a sobering chart and one that the sector (both the producers and the Chinese) are well aware of, as I’m sure Treasury is. But don’t forget, it’s different this time. And different it just might be.

            Whilst you’re weaving your hair shirt, you might enjoy this discussion from The Sydney Writers Festival: The Future – USA or China (and/or India).

            When considered in the terms discussion Treasury is likely to be correct in the long haul. Chinese growth at say 5% is still huge and with the increasing industrialisation of India, the subsequent further demand for Australian resources should ensure resources continues to play a major role in our economic future.

            We do indeed need to make space for a continued resources boom (although there may be hiccups along the way).

            A commenter here the other day said something along the lines of ‘hike rates and be done with it’ and I reckon that is was Treasury would like to do, if it had it’s way. RBA’s charter requires more finessing.

          • Your response to “That chart just screams BUBBLE” is “This time its different”.

            Are you serious?

            You don’t need to tell me what the Treasury view is on China — I’ve heard it a billion times — but the same boffins saw nothing on the horizon in 2007-08, they saw a Japanese Century in 1989, and there were a helluva lot of people who bought into the “new economy” in the late 90s including one A. Greenspan.

            I’m sorry, but it looks like a bubble, smells like bubble, so its probably a bubble.

          • No-one is denying it looks a little bubbly – and there has been plenty of that flowing, I can assure you. The resources sector understands the unpredictable nature of commodity pricing better than any other I suspect – it’s how it is. You gotta make hay whilst the sun shines.

            ‘Different this time’ – well partly tongue in cheek but not impossible!

            I’ve already said I don’t buy what Treasury is selling, not such a rosy view for such an extended time line. But I am prepared to be proven wrong, welcome it even.

            Also as I’ve said, I think pricing for ore can be expected to be good for a couple of years, maybe a couple more. Then I would expect a return to more modest levels.

            If emerging economies have difficulties of their own in the near future – you are not going to stop the growth entirely and at some point upward trajectory will return. Steel being an integral part of infrastructure development the demand for ore, even if it moderates for a period, will regain impetus.

            With so many uncertainties in the global economy you can only hope for the best.

            And for the record, I listen to very few boffins, largely sharing Taleb’s view that economists are about as accurate at prediction as astrologers, and possibly less accurate.

  4. Alex Heyworth

    Even at $100 a ton, with the expected production volumes that is a huge amount of moolah to the iron ore majors. Australia’s exports are projected to reach 900 million tons a year in the not too distant future. That’s $90 billion a year in export earnings.

    • MontagueCapulet

      It could happen that way.

      Or Chinese demand for steel could level off and we could be exporting 900 million tons per year at $60 per ton as the market becomes oversupplied.

      Which would make the total export income about the same as it is now. But profits would be a lot lower as costs would account for $30-40 per tonne. So the share price of BHP and Rio would take a dive, and the ASX would get hammered.

      I expect that the Chinese will increase steel production until there is an oversupply, then they’ll close some of the smaller mills and rationalise the industry. So as iron ore producers ramp up to meet demand they’ll eventually be creating overcapacity, but this won’t be apparent until the Chinese start closing steel mills.

      • Close attention is paid to all inventories.

        The nature of mining investment is that, yes, sometimes it goes pear-shaped. The long timeframe in construction of new or refurbishment of existing mines in order to increase production always carries a degree of risk. But at some point, a combination of best indicators and a dose of faith, gets these projects developed.

        I’ve never liked the “oh but when production ramps up the bottom will drop out of the market” mentality. It is just a fact of life in resources – there is no guarantee of future price years hence. But you know what, someone took the chance. Companies take that opportunity, develop wonderful infrastructure all with a long-term goal – because in resources you have to have that view, that and a dash of hope.

        Very easy to shoot it down in flames, point the finger when it fails. If someone didn’t take a chance we’d all be living in caves.

        So try a little optimism – just accept it is not a perfect science. But what the hell, when it’s good, it’s really good!

        In a country like Australia the mining industry should be supported, not threatened with penalisation of some sort or other at every turn.

        My 2c. Again.

  5. Sandgroper Sceptic

    Isn’t there a push to close quite a few steel mills which are massive users of power due to the looming power shortage coming up for this Chinese summer? From memory the Chinese economy will be some 30 GW of power short for summer and many energy intensive factories, including steel mills will have to be closed or operate at less than 100% capacity utilisation during this time.

    Obviously this is only a short term negative factor for iron ore pricing but it may enable the rationalisation of smaller steel factories which might be permanently shuttered after this summer.

  6. To 3d1k and The Lorax:

    No-one is denying it looks a little bubbly

    I am. Read this:

    Over the last 100 years prices have risen substantially during periods of large scale industrialization. Unfortunately the charts that people trot out tend to begin during the global bear market in commodities, therefore the current high price levels are made to look enormous but they include the retracement of the bearish values.

    • That RBA paper was written in April 2007. Says it all really.

      Sadly our central bank has been one of the biggest proponents of the commodities bubble. Even the most bullish analysts are less bullish than Ric “Boom Boom” Battellino. You’d have hoped for a more cautious approach from grey-haired bankers, but no, they’ve put all our chips on the boom.

      Funnily enough, the hard-core laissez faire types are also (typically) hard-core Simonites. Their deeply held view is that commodity prices decline in the long term, except of course, when it comes to Quarry Australia. Apparently an incredibly abundant mineral like iron ore will forever rise in price, but suggest to them we might have a problem with Peak Oil and they dismiss you as a Malthusian.

      A deeply conflicted lot. e.g. Sinclair Davidson.