China’s ore build a dodgy dash for cash?

Bloomie has a story today that suggests the recent big spike in Chinese iron ore inventories is the result of financing deals:

Companies seeking funding amid government efforts to rein in lending and shadow banking are shipping more ore to use as collateral, said Xu Xiangchun, chief analyst at researcher Rising purchases by China, the world’s largest user of the material, may reduce a global glut forecast for this year by Goldman Sachs Group Inc. and Credit Suisse Group AG.

“Steel prices have fallen sharply and demand remains weak, so there are no fundamental reasons supporting such a big jump in the raw material imports,” Xu said by phone from Fuzhou today. “The only plausible reason is financing deals.”

This sounds similar to yesteryear’s “cash for copper” scams:


In essence, some Chinese market participants – particularly those that are highly leveraged – are buying non-domestic copper material in order to raise CNY cash, in a development we have not seen since mid- 2011. Specifically, CFC financing – which is allowed by SAFE, and has been a factor in the copper market for years – involves the purchase and importation of non-domestic copper into China, the immediate sale of this copper into the Chinese domestic market post-importation (for immediate CNY cash), and a 3-6 month loan at foreign interest rates issued by an onshore bank. In this way CFC’s are a combination of the China/ex-China price and interest rate differentials.

The recent increase in short-term Chinese rates has resulted in CFC’s being highly profitable. Put differently, the interest rate differential adjusted copper import arbitrage is now substantially open – raising China’s demand for non-domestic material, and likely contributing to the recent pick-up in Chinese bonded physical premia (to record highs of $180-$200/t), higher LME Asia cancellations, and tighter LME copper spreads. In this way, interest rates differential changes, via CFC financing, can change where global copper inventories are located (today there is a pull on non-domestic copper inventories into the domestic market).

While these developments are typically a sign of a tightening copper market, we believe that market participants should be wary of interpreting these recent ‘signals’ – including future resulting copper import strength – as bullish, since they are in large part driven by Chinese liquidity tightness, and not primarily driven by real Chinese demand/re-stocking.

So what happens if the price suddenly falls? I would have thought there’s a danger of a margin call meaning the collateral gets dumped into the market as the borrower needs more cash or the bank seizes and sells the collateral. All insights welcome here…

David Llewellyn-Smith
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  1. Chinese iron ore traders, without exception, use enormous amounts of debt to finance the transport iron ore, largely on spec. Moreover, they still make up a significant portion of the iron ore market in China, with only the majors have long standing contracts with major steel producers (although in saying that, there is some Robe River spec available apparently). It has been a highly profitable venture for near on a decade with continuing high prices.

    The problem is for many of these traders is when the steel mills don’t want their product, they have to file for bankruptcy, given traders don’t have any financial capability to sustain their contractual obligations, particularly with Australian junior I.O. producers. I think the majority of investors have no idea what a precarious industry this is.

    If one recalls a year ago, there was quite a sharp drop in iron ore prices– at the time, it appeared that the vast majority of trading houses would simply disappear. Those who took delivery on iron ore shipments, and managed to roll over their debt repayments, were able to sell it at enormous profits (given this is margin expansion business) just several months later as prices jumped from around $90/t to $150/t. Much of this was driven by supply shortages bought on by 100mt of Indian supply just going off-line (the current PM was Resource minister at the time many mining licenses were issued under very dubious circumstances). The Chinese banks also were let of the hook, potentially having enormous amounts of iron ore collateral with no real market.

    However, I fear that the wrong lessons have been learnt from that episode, by all concerned. If demand drops and/or Indian and continued growth in Australian (especially from Rio) supplies add pressure to an already slowing construction market – we could see a massive squeeze – from which there will be no future price rebound, or stockpile drop. And I suspect, the banks will continue to finance imports for a while – assuming things will eventually turn around; until even they realise what a catastrophic situation they have created. Then the poo will really hit the fan.

    People forget that last year FMG was potentially only a week away from being restructured. Twiggy is no fool – he alone has been the only new major supplier globally (now number four) during this entire decade long mining boom; which is an incredible achievement. And I suspect he ais one of the few who recognises what is just around the corner. How do we know ? Play this game – watch what I do – not what I say… Despite their grandiose talk – FMG finished expansion plans ASAP, on time and budget, knocked all other proposals on the head –THEN – as far as a I am aware, there has never been any faster pay down in history of outstanding debt from a major Australian corporate, which is still ongoing. Make no mistake – Twiggy is a smart (aka wise) cookie. he will not be caught twice !!

    • Thanks dude. The kind of price carnage you are describing would push IO below FMG’s break even and keep it there for a long period. Maybe it could survive but its equity would get crushed.

  2. I was thinking the same, given the forward curves in both Copper and Iron Ore are in backwardation.

    How can one tell what proportion of the large stockpiles are provisioned as collateral and what is not? Surely this is a key factor in determining what the true days worth of inventory the mills have in play?

    • The collateral provisions would be confidential between the traders and the Chinese banks. But it would be safe to assume that all of the iron ore would be under bank ownership, usually I.O. sales in Australia are done on a FOB basis, with payment made pretty quickly after shipment. There are other provisions for contaminants, (e.g. Al, P – even Fe content, split between fines for sintering and if your lucky, lump). But these are typically later adjustments on a continual basis.

      The big losers would be small producers and mining contractors. When (not if) this balloon goes up, iron ore shipments will not just slow down, they will stop – dead. Indefinitely.

      There is an historical basis for this. In the run up to 1929, new building techniques allowed (along with the advent of escalators) for the first time massive buildings requiring enormous amounts of steel, especially in the US, at the time amazing building including the Chrysler building, Empire State were completed. As history shows, that peak in iron ore demand was in 1929. From 1929 to 1932, global blast furnace production dropped 50% globally. It didn’t reach its former peak until 1937 (then another market crash), and didn’t then again reach that 1929 level until 1941, several years into WW2. In 1945, it dropped 35% before recovering in late 1948 to 1952, when the Marshall Plan was totally rebuilding Western Europe – coupled with Russia rebuilding as well. Thats a 20 year gap – under some pretty exceptional circumstances.

      A couple of unique things about iron ore – its demand actually fuels the growth in demand. What I mean is, take China, it needs rebar for construction. To get more iron ore, it needs additional shipping (that use a lot of steel plate), rail infrastructure (more steel) and blast furnaces (lots more steel), trucks (steel), and building equipment (steel) and associated infrastructure (e.g. cement production – lots more steel). Demand therefore, is self-fulfilling, and it is extremely difficult for the steel producer to discern (assuming they were in the remotest inclined to do so) what is real or underlying demand (lets say for housing) is – compared to what cumulative notional demand suggests, to acquire the necessary infrastructure achieve iron ore supply.

      Conversely, that is the simplest explanation I can think of why the steel industry (and by direct relation iron ore industry) always massively over shoots – and there are these enormous demand and supply swings.

      So in short, a couple of conclusions:

      1 – If China property crashes, a 50% decline in global demand is not unprecedented, and would be my first inclination as a predictor – the affect that would have on the iron ore price, I don’t have a good handle on, that is in the realm of DH at Metalytics – but 50-70% of current price is not unreasonable from a sanguine perspective;

      2 – Iron ore prices (although I love looking at them) are in fact a lagging indicator, as are various steel products. Hence macro-businesses obsession with the rebar price (by design or not) is in fact very insightful; and

      3 – Realistically, the implications for the Australian mining industry will be nothing short of catastrophic. Remember that Rio’s >75% EBITA is now solely based on Australian IO, a proportion that is continually grow in percentage terms. Rio is no diversified miner – with the amount of current debt and continued expansion – I believe that surely they are a candidate for being restructured (big call I know) – along with every other smaller Australian iron ore producer (bare none) going to the wall. Jim Chanos – I have no doubt, will get the last laugh on this one…

  3. So who is going to get caught with their pants down when this rehypothecated daisy chain goes up in flames? Could spread far and wide