Yesterday saw the little bounce in the ore price continue with spot up 0.76% to $119.30, 12 month swaps reversed course and were down 2.1% to $125.55, whilst Shanghai rebar was again little moved. This looks like a weak bounce. I’m not confident that the correction is over.
But today I want to discuss what kind of correction we are facing and the best way to do so is via an outstanding Morgan Stanley report that seeks to put the current correction into the longer term supply constraint context (and does so admirably). The report is uber-bullish for the long term but, if it has a weakness, projects the current macro settings rather optimistically forward, much like an official Budget forecast does, rather than taking into account the very likely possibility that those macro settings will shift, perhaps dramatically. Still, we can’t base our projections upon unexpected outcomes, can we? So let’s take a look.
Firstly the report sees the current correction as caused by a convergence of various forces:
• The current weakness in Chinese spot cfr iron ore prices, in our view, reflects the combined impact of cargoes displaced from Europe by cyclical weakness in demand, and a steel inventory de-stocking cycle and seasonal factors in China.
• While near-term demand factors dominate in the current aggressive price correction, spot price weakness has been exacerbated by aggressive producer selling into China from Australia and Brazil, as Indian supplies dwindle, and credit restrictions limit the participation of Chinese traders in the seaborne market.
• In the very short term, we expect spot prices to trough between US$95/t and US$120/t cfr North China, before stabilizing ahead of an anticipated rebound once Chinese inventory destocking is complete.
The report also provides this a neat chart which shows clearly how sensitive ore and cocking coal prices are to blast furnace throughout rates which, encouragingly, does suggest a market driven by supply and demand:
So, global weakness, Chinese weakness and iron ore inventory cycle, as well as renewed competition. Much the same as we’ve been describing here at MB. The correction prices and timeframes look reasonable to me as a base case. What they lack is a sense of two serious risks. The first is the likely prospect that Europe will deteriorate further. To me that is as near a certainty in macro economics as you get. So the global iron ore market is likely to be suffering from demand slackness even if China can manage its way through its attempt to cap real estate prices without triggering a bust.
The first reason is why I do not expect the iron ore price to rebound sustainably for some months. The second is a risk that I cannot quantify. Nomura puts it at 1 chance in 3. In that event, the ore price might stay at these levels or lower much of next year.
Morgan Stanley, on the other hand, expects a relatively swift rebound after some price weakness extending into early next year:
There will, in our view, be price consequences into 2012 from this correction as the average of 4Q 2011 spot prices will be substantially below consensus expectations, and reset the basis of 2012 prices lower in 1Q 2012. Consequently, we have lowered our 2012 62% Fe fines cfr North China price by 7% to US$160/t.
• However, falling output in India due to the continued ban on mining in Karnataka, and anticipated seasonal effects on Australian and Brazilian output are expected to tension supply in the seaborne market in H1 2012.
• When combined with restrained domestic supply due to the lagged effects of the current price weakness on mine operating rates and an anticipated iron ore and steel inventory restocking cycle also in H1 2012, we expect spot prices to recover most of their recent losses during this time.
•. Over the remainder of 2012, we also expect prices to remain strong but below our previous forecast levels as deficit conditions in the seaborne market are expected to prevail. However, given we are forecasting a larger seaborne market deficit in 2013 than 2012, we are lifting our base case forecast to in CY 2013 to US$165/t. Details of these quarterly price forecasts are shown on page 3 of this report, while details of our projected seaborne market supply and demand model out to 2016 are shown on page 21 of this report.
As said, I expect European weakness and its implications to prevent this kind of rebound next year. Though I do expect a rebound, especially as the market anticipates China easing.
In the longer term, however, the MS study makes a reasonable case for the ongoing strength in the iron ore price. First, it projects a roughly 5% growth rate for global and Chinese steel output over the next five years from today’s one billion or so tonnes to above 1.4 billion tonnes in 2016, with China’s steel production alone approaching one billion tonnes per annum from today’s sub 800 million.
Given the macro uncertainties facing the world, I wouldn’t use such a growth rate but it’s not historically unreasonable. Building from this assumption, the report then illustrates that although Chinese production of iron ore grew from 231Mt in 2002 to 1,065Mt in 2010, ore grades:
…have declined from 39.2% in 2003 to only 23% in 2010 and are forecast to drop as low as 18.8% in 2012 before stabilizing around 20% out to the end of our active forecast period in 2016.
The result is a projection that China’s dependency on imported ore is set to grow from around 60% of its total needs to almost 80% by 2016. Moreover, MS assesses the production costs for its own projected iron ore mining to be concentrated in the $100 to $150 region, putting a floor under prices when they do correct.
In the end, though, I return to my original point. There is no suggestion anywhere in the MS report that China might be forced or choose to alter its fixed-asset investment driven growth path. In that event I would still expect a booming Chinese steel industry but not one that can grow at rates that continue to outstrip the global supply response, which MS sees growing from today’s 1.8 billion tonnes to 2.6 billion in 2016.