Macquarie: Iron ore to keep falling

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From Macquarie today:

 Iron ore and Chinese steel prices have seen a long overdue tumble over the past few weeks, as the exuberance in pricing and demand expectations has begun its journey back to more fundamentally supported levels. As per any other classic pricing cycle, supply has responded to high prices and margin incentives and ultimately overwhelmed demand, while restocking has come to an end. Chinese crude steel output surged to a record high in March, exceeding the level last seen in May 2014, while in iron ore both imports and domestic Chinese supply have surged in recent months, leading to a clear excess building in inventory, which is now being more aggressively sold.

 The key questions for pricing direction near term is whether pessimism now builds to a level that causes prices to overshoot to the downside amid an aggressive destocking cycle or do underlying solid demand foundations help to limit a further decline in prices.

 Spot 62%Fe iron ore prices have fallen from a recent peak of $94.5/t in late-February to $61.5/t on Tuesday, according to TSI, a fall of 35% in the space of six weeks. The drop in spot physical iron ore prices is in line with the decline in Dalian futures prices, which have fallen by 31.7% from their February peak. We have long been saying that we think fundamental support for iron ore lies around $50/t, and we would thus expect prices to continue falling further now they are in a clear downtrend.

 The plunge in prices has not yet led to much rebalancing in terms of grade relativities, however, with 58%Fe prices down 37% over the same period and 65%Fe prices off by 29.2%, in fact resulting in a widening of the grade differentials in percentage terms, according to Platts. Lump premiums meanwhile continue to fall, reaching a new low of only $0.0155/dmtu.

 With iron ore prices having rolled over, port inventories have also peaked, as traders, who were happy to sit on inventory when prices were rising, have now started to sell more aggressively. According to Mysteel, data inventories at 45 major ports peaked at 134.6mt at the end of March and have dropped just over 2mt over the first two weeks of April. With mill inventory levels still above average, we would expect mills to see a further destocking of iron ore now prices are in decline, which will exacerbate the weakness and potentially result in prices overshooting to the downside before mills return to replenish inventory again.

 Iron ore supply is finally overwhelming demand, as we have been expecting, with a clear response to the higher prices seen over the start of the year, as evidenced by the latest Chinese trade data. Iron ore imports increased 11% YoY to 95.56mt in March, and 1Q17 imports are up 12.2% YoY to 271mt. Along with higher imports, China’s domestic iron ore production is also picking up, with Mysteel showing 266 mines’ average capacity utilisation rate rising to 69.5% by mid-April, the highest level since October 2014.

 The fall in iron ore prices has come as steel prices have also begun to roll over on the back of surging supply and a realisation among steel market players that perhaps demand will not come through as strongly as previously expected. The latest NBS production data shows Chinese crude steel output hitting a record high in March of 72mt, nearly 1mt above the previous peak level seen in May 2014. Of course part of this output is reflecting the replacement of previously underreported output from induction furnaces that have largely closed, but even this we estimate to account for no more than 40mt of additional output in the headline statistics.

 The decline in steel exports, meanwhile, means that 1Q17 apparent steel consumption was up just more than 10% YoY. We believe real demand growth is likely running at a level below half of that, which means there is a clear oversupply in steel domestically, and we would expect to see Chinese steel prices continue to fall until they reach a level at which steel mills can once again look to the export market as an outlet for the oversupply in the domestic market.

 Another reason that steel prices will likely continue to decline is that steel margins are still in positive territory for rebar, meaning mills are unlikely to cut output near term, although HRC margins have recently turned negative. While iron ore prices have plunged, met coal prices have been more resilient in China, although they have not witnessed the knee-jerk reaction in seaborne markets to the loss of cargoes due to flooding in Australia. Coking coal prices in China have, in fact, fallen over the past couple of weeks despite the surge in the illiquid seaborne market, as pessimism around the whole steel and raw materials space has started to impact all steelmaking ingredients in China.

 With prices for steel and iron ore both now in decline and a clear destocking cycle underway, we expect price declines to continue near term. However, underlying steel demand should be seasonally robust in China as 2Q normally represents peak demand in the construction cycle every year, and this may be enough to prevent traders from selling cargoes too aggressively and causing a short, sharp downward move in steel prices. For iron ore, however, we still believe prices should be back at a fundamentally supported $50/t level per our 2H16 forecasts, and thus we still see potentially at least another 20% downside to prices from current levels to start pressuring some of the marginal supply that has recently reappeared to again exit the market.

Quite right. Only thing is, $50 won’t be low enough to push supply out. Conservatively, we need to see 50mt removed from supply just to fit new tonnages arriving this year. My view is that apparent demand has inflated underlying by another 40mt or so. So we need to see 90mt of iron ore capacity rationalised. $50 won’t do it, especially so since Chinese supply is now 15% cheaper than it was in 2015 owing to forex and further cost-out. $40 ought to be enough.

But then you have to add inventory destocking, Chinese slowing, and another 40mt of new supply next year.

New lows by year end I’m afraid.

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About the author
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.