Yesterday’s iron ore prices showed more stability:
ANZ also produced one of its semi-regular special reports and, although it has cut its forecasts for 2013 and beyond, remains attached to the iron ore price floor theory in the longer term. It’s worth a read for its assessment of how grim things are currently in Chinese steel:
The key negative dynamic, and one we have underestimated, has been the inelastic Chinese steel supply response to falling prices. It appears strong political pressure is a factor behind the stubbornly high State Owned Enterprise (SOE) output. The government controlled entities are being propped-up by subsidies or operating at mild losses to sustain social stability (high employment and state revenues) through the very sensitive 1-in-10 year leadership change-over period. Margins for smaller mills have also been protected by sourcing cheaper lower-quality domestic raw materials and skirting many of their environmental and tax obligations.
We estimate steel output in China is running about 15% above required demand (FIGURE 2). Unsold steel production is being stockpiled on the hope of selling at a later date. We suspect mills have produced an additional 10 million tonnes of steel per month over the past 4-5 months, adding 40-50 million tonnes into steel yard stockpiles (normally levels closer to 10 million tonnes). With subdued demand conditions expected for the rest of the year, we believe it could take up to six months to unwind the excess inventory, keeping iron ore prices capped in the meantime.
We believe steel mills are also working a lot closer together to keep prices down. Gross China steel industry margins have hovered around a measly 1.0% for most of 2012, triggering a very strong focus on cost containment and an increased level of industry collaboration. We hear many are being discrete in purchasing from the seaborne iron ore market preferring to run down high port stockpiles to keep prices from rebounding strongly. Not surprisingly, China iron ore port stocks have fallen 3 million tonnes off near record high levels of 100 million tonnes in the past month after constant stockpile gains since early March.
…We expect the next phase to be the closure of high cost China iron ore production. We estimate that over half of China’s iron ore supply (equivalent to 150 million tonnes of seaborne supply) has a breakeven cost between USD120-140/tonne. In fact, we are hearing reports that as much as 40% of China’s domestic iron ore supply has been halted in the past few weeks after domestic iron ore prices slid to USD120/tonne in early September. While this would seem positive for seaborne iron ore prices, we think it will trigger the closure of the high cost SME steel mill capacity which relies heavily on domestic iron ore supply. The short term impact will be lower iron ore demand and a justified drop in overall Chinese steel output. This should help reduce excess steel stocks, but only slowly, while demand remains subdued.
Well, perhaps, but potentially that looks like the same mistake that the ANZ just confessed. Moreover, ANZ has extended its expectation that we’ll see the same nice market-clearing reduction in Chinese iron ore production when it will almost certainly be prone to the same protectionist impulse afflicting the steel market. Some clearing action is certain but 150 million tonnes is pretty optimistic.
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Which leads to some pretty happy conclusions:
We think iron ore prices are settling down and should trade in USD100-110/t range for the next 3-6 months, while the steel inventory overhang and uncertain China demand profile remains in place. We expect better gains in the second half of 2013, but pricing power will be more balanced, meaning a more sustainable trading range closer to USD110- 130 rather than USD130-150 will be realised.
Hmmm…the short term forecast I agree with. Chinese stimulus efforts will filter through and industry consolidation continue. But beyond that I expect the reverse of ANZ’s outcome (unless China goes all in with more stimulus), that is, for iron ore to resume its decline as China pursues its structural adjustment to consumption-led growth. That means no growth in Chinese steel demand (it may even shrink). There’ll be bugger all demand growth globally either and meanwhile committed plans for total seaborne supply will grow at 10% per year (some estimates are as high as 14%) for the next three years. That’s around 100 billion in new seaborne supply each year. If Chinese supply doesn’t conveniently lay down and die then we’re in a structural glut for iron ore. Let’s face it, another way to restore steel profitability is to squeeze its greatest input cost.
So, to me, beyond the short term, it is more likely that the we’re going to see an iron price that has to be low enough to pressure not just Chinese supplies but higher cost seaborne supplies as well. That is a range more like $80 to $100. Expansion plans are going to have to go. In Australia, it’s not hard to work out who is in the firing line.
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.
