Iron bomb

Australia’s lifeline in China, John Garnaut reported this morning the worrying news that:

The Chinese steel mills that have been holding up the Australian economy are under pressure, with steel prices falling and iron ore prices expected to follow.

Robust steel demand in China led Australia to post a record $5.9 billion in iron ore exports and the second highest trade surplus in July, according to figures released yesterday.

Chinese spot prices remain stable and high, above $171 per tonne for 62 per cent iron ore, and Australian producers have mostly locked in high prices until the end of this year.

But this might be as good as it gets because steel producers are cutting prices and market sentiment is rapidly deteriorating, analysts say.

The steel and iron ore markets were bracing for ”volatility on a declining trend”, said Yin Jimei, an analyst at Iron & Steel Information Website in Tangshan.

Xu Xiangchun, at Mysteel in Shanghai, said market anxieties over the global economy had coincided with softening domestic demand including a pullback in railway construction due to a series of scandals in the Ministry of Railways.

Prices for ”rebar” construction steel fell 2.6 per cent last week and they have dropped 8 per cent since mid-August, said Paul Bartholomew at Steel Business Briefing.

In my post yesterday about the record trade data, I made similar points about the steel price and promised to return with some charts on iron ore futures and swaps. Well, here are 12 month swaps and I am not reassured:

I think it’s fair to say that that is not pretty. But let’s take a look at a longer time frame.  The iron ore swaps market has only been going for two years or so, as the old annual benchmarking pricing regime declined and opened the opportunity for derivative trading:

Now, that puts the falls into perspective.  But there is still cause for concern. First, there was obviously a much larger correction during 2010’s combined Greek bailout and US double dip scare. This came to an end with the commencement of QE2 in the US. Those that maintain the argument that the iron ore contract system prevented the effects of financialisation that took hold of other metals might take pause at this chart.

We can’t say for sure, however, becasue the iron ore market has also been strongly supported by oscillating problems in Indian supply owing to political interference that began at the same time.

What we can say is that the macroeconomic circumstances are now much worse than they were in mid 2010, so iron ore swaps still look overpriced on that basis (even accounting for Indian supply concerns).

This is captured nicely in the technicals of the chart which shows a nasty double top and violation of the 200 day moving average (yellow line). Both suggest considerable downside ahead.

But what’s the relationship between iron ore swaps and the spot price? Let’s take a look:

Obviously, there’s a strong correlation with the swap market absorbing more of the speculative activity than the spot price, which is good news. But it also shows just how much further swaps will have to fall if they match 2010. It seems to me entirely plausible that iron ore swaps (and spot) could plumb the 2010 pricing lows on current slowdown in the West and China. As John Garnaut tells us, steel prices in China are already falling.

A more difficult question to ask is what happens if the Western economies slide into recession (as is my base case). The chart above shows the 2008 collapse in the ore price. It was triggered when the Lehman shock froze world trade and China’s export sector hit a wall. As a result of collapsing demand, Chinese steel mills stopped buying ore, defaulted on contracts and drew down on existing supplies. Here is a chart of iron ore stocks in Chinese ports. I’ve circled the inventory draw down:

You will note that there was a huge run up in stocks that led to the record trade numbers before the crash. We have seen a similar build up recently.

Australia still has some protection against these cyclical swings in the ongoing quarterly pricing contract system. But nobody seems to know any more just how much of our iron ore is sold in this old system and how much on monthly or even shorter contracts. One must seriously question whether in the long term the trashing of the contract system won’t come back to haunt us.

As I’ve confessed before, the iron ore market has made a goose of me several times. Certainly it appears China is going along OK for now. But the iron swaps market looks ugly and is signaling significant spot falls already. I don’t think we’ll see a full blown inventory cycle unless we also see a big European shock. But that’s not so unlikely is it?


  1. I was in the coal export industry in the late 80’s and saw the Japanese renege on contracts when they needed less coal. It ended up in retrenchment for me and lots of others. No regrets though. I can see the same pattern here. Happens pretty quick, too.

    • Good contribution Rod.

      The Chinese reneged on their iron ore contracts in 2007 too, and Australia didn’t exactly take them to the international trade tribunal.

  2. Ultimately many people/consumers must pay for the high iron ore and resultant steel prices in the products, properties or services they use. Can anyone explain to me why and how that will occur in any sustainable way?

    Secondly if prices are not sustainable for whatever reason, wont prices have to reduce below the sustainable mean so that the long run affordable average is maintained?

  3. “But nobody seems to know any more just how much of our iron ore is sold in this old system and how much on monthly or even shorter contracts. One must seriously question whether in the long term the trashing of the contract system won’t come back to haunt us.”

    I believe BHP has moved to virtually all monthly pricing.

  4. Those that maintain the argument that the iron ore contract system prevented the effects of financialisation that took hold of other metals might take pause at this chart.

    When put side by side to base metals charts anyone maintaining that should feel comfortable. The iron ore spot prices began a sharp rise upward in July 2010, well before QE was implemented and well before it was flagged. But that aside if there is a drop in demand there is likely to be a drop in price. The dominance of speculators, especially with the ability to naked short, merely accentuates the movements. But the absence of speculative dominance doesn’t mean that prices can’t fall or fluctuate and “maintainers” have never said that. Given a constant supply — true over a small time frame — swings in demand for iron ore, in turn linked to demand for steel, influences prices. But with base metals you have to contend not only with swings in demand for the metal, but swings in demand for the paper by speculators.

    On your correlation chart I’m wondering if the green line is a magnetite price. It is way above the 62% spot prices linked on the margin of this webpage and cited in the Garnaut article.

    Your stocks chart, while informative, probably should be normalized to steel output or total iron ore consumed for better guidance, e.g. stocks are higher now but so is total iron ore consumed. As a % has it changed that much?

    Australia still has some protection against these cyclical swings in the ongoing quarterly pricing contract system.

    Contracts with Chinese steel mills were shown to be not worth the paper they are written on 3 years ago. Doubtful if contracts exist they would be honoured in the event of another crash.

    But the iron swaps market looks ugly …

    Bit of a stetch and worth remembering that at the moment the spot rises have actually risen in aussie dollars, i.e. strayan miners are better off (provided they don’t have currency hedges).

    • Actually, iron ore turned the same time as base metals and the CRB, in anticipation of QE2 around June/July.

      On ore price chart, you’re right, the pricing scale is wrong. I’ll check that. Nonetheless, it would make no difference to the points I make.

      Yes, prices have risen in AUD, but that ain’t gonna last. Either dollar goes back up or ore comes down…

      • Where I think you miss the point I have made a few time on this blog is that the absence of exchange traded pricing doesn’t mean prices can’t and won’t fluctuate. The comparison between exchange and non exchange traded is about two things:

        1. volatility. You aren’t seeing the kind of volatility in contract prices as you are on exchange traded ones; and importantly

        2. price reflecting underlying supply/demand tensions.

        If price drops because of a lack of demand for iron ore then so what, that’s what you’d expect. With base metals any connection between price and underlying industrial supply/demand — certainly since April 2009 — has been coincidental, if not accidental.

        So contracts won’t prevent iron ore from falling, but the fall will reflect what is happening on the ground in steel mills much much better than a fall in e.g. copper, reflects how much copper piping and wire is being made.

  5. On the plus side all those illicit Chinese workshops stretching the rebar from 10mm to 8.5mm will trigger a new construction boom in a few years when everything built in the last few years requires rebuilding…

  6. “The Chinese steel mills that have been holding up the Australian economy”

    whats he smoking?

    Iron Ore exports to China was $34.6B or 2.9% of GDP. Whats the other 97.1% of our GDP Scotch mist?

    • He’s 100% right. Without the export revenue and investment boom, nobody would lend us a dime ie the cost of financing your home would be much higher and everything else would be much lower, except unemployment.

      Make no mistake, iron ore is the foundation upon which the Australian housing bubble rests.

      • Like I and many people have previously said in the end we will have holes in the ground and a whole lot of debt to show for it as we pledged every little bit of mining money as collateral for even more debt (directly or indirectly).

        Sometimes I think it is better if the mines were never there.

    • “Iron Ore exports to China was $34.6B or 2.9% of GDP”

      3Q11 estimated iron ore export tonnage is at about 440mtpa rate (only counting the Pilbara ports and ignoring the smaller non-Pilbara ports). So on $160/tonne FOB wet basis, it should give about USD70 billion of annual GDP.
      Also, it takes coking coal to produce steel so one should add the value of coking coal exports. Annual export rate is about 150mtpa. At $300/tonne, that’s another USD50 billion of annual GDP.
      The two combined are USD120 billion, so give or take the FX rate fluctuations, should give you about 9-10% of GDP. I’m ignoring thermal coal of about another 180mpta or USD18 billion (at $100/tonne FOB).

  7. Diogenes the Cynic

    Tears before bedtime…in our near future…

    Any contract that forces immense losses on the buyer in China will simply not be honoured. Of course BHP and Rio won’t disappear their mines are top quartile in terms of lowest marginal cost but their profit margins are going to shrink.

  8. In light of the fact that my countering the stupidity of the assertion IS NOT BEING published, I’ll rip this apart on my blog on Monday (work, trading and rugby have priority over stupidity meets vanity).

    • you too! even though the housing bubble preceded iron ore boom by years it is now iron ore’s fault 🙂