Terrific stuff here from Westpac’s Justin Smirk:
•Demand for iron ore has been very robust this year but more importantly there has been the collapse in Chinese ore production in response to industry reforms as well as a soft patch in imports. The more rigorous implementation of environmental policies has hit iron ore miners hard.
•Chinese steel industry reforms boosted the remaining steel mill margins thus supporting higher input prices.
•The focus on improving efficiencies has increase the demand, and the premium, for higher grades of iron ore while domestic ore prices are supported by the collapse in supply and the rising cost of production.
•Our forecasts for flat Chinese steel production in 2019, and a modest lift in ore imports, drive our forecast for modest price correction in iron ore prices. However, the discount for 58%fe is likely to remain around 40%.
Demand for steel has fared better than expected but it is not the start of a new cyclical upswing.
The demand for steel grew robustly in the first half of 2018 despite the Chinese governments best attempts to de-leverage the economy. Apparent Chinese steel consumption is up 8%yr in the first half of year but it is closer to 4% if you take into account the impact of the closure illegal Electric Induction Furnaces (EIFs) . Property has been a key driver of this, which has been reflected in the robust lift in rebar prices, but we believe this reflects a cyclical restocking of property rather than a new structural upswing in property investment.
Chinese structural reforms are having a significant impact on steel production.
Through the first half of 2017 highly polluting, inefficient and illegal EIFs were closed on a broad scale. Wood Mackenzie estimates that around 49mt of steel produced in 2017, as measured by the official data, was replacement for lost illegal EIF production (that is not measured in the data). In 2017 Chinese steel production officially increased by 35mt suggesting that without the closure of the EIFs reported steel production would have fallen. The pace of closures is far less significant in 2018 but nevertheless, it is estimated that by end 2020 some 120mt of steel capacity will be lost due to the closure of illegal EIFs.
The loss of output from EIFs, in a relatively tight market, boosted the profitability of Chinese steel mills more broadly. So despite rising input prices, Chinese ferrous metal smelting/pressing margins have improved back to levels not seen since 2007. Chinese steel prices may have flattened but they still hold sound levels and remain supportive for the price of inputs into steel production.
The changes to environmental policy, and its impact on smaller less efficient steel mills, is apparent when you look at the share of loss making steel firms. Despite firm steel prices and a reported surge in steel mills’ average margin (from ~2% in 2016 to an average of ~6% so far this year) the share of loss making firms has jumped to 34% in June (from a recent low of 21% in September 2016). In the past it has taken a collapse in steel prices to drive such a surge in loss making firms. That this surge in loss making at a time of firm steel prices suggests other factors are at play, in this case both the environmental and financial constraints being placed on the smaller companies as the administration implements industry reform.
Chinese steel mills have also turned to higher grades of inputs to improve efficiencies and reduce emissions. You can get more steel out of a blast furnace, without increasing the total volume of inputs, by using higher grades of inputs. This focus on the quality is behind the significant lift spreads for the higher grades iron ore (and met for more met coal see “Structural Reforms Are Boosting Met Coal Prices”). Compared to the 62%fe benchmark the 58%fe discount has fallen to 40% as Chinese steel mills focus on higher grades of ore to improve efficiencies and lower costs.
There is also another factor at play here – that due to tight supply conditions the price for domestic inputs for Chinese steel mills remains elevated compared to the price of imported coal and iron ore. As many of the smaller mills rely on domestic input due to their distance from the coast, the closure of Chinese mines has supported the price of domestic coal and iron ore relative to the price of imports. This burden would fall disproportionately on the smaller less efficient inland steel mines and would also help to explain the jump in loss making firms despite the industry wide improvement in margins.
Environmental and financial reforms crushed Chinese ore production while significantly lifting the grade premium.
China typically mines lower grade ore of <20%fe which is then beneficiated (refined) up to 60% to 66%fe. Chinese iron ore production hit 268mt in 2017 which is estimated to have been equivalent to 193mt of 62%fe (around 10% of the global iron ore supply). But so far this year, the official data suggest that Chinese ore production is down more than 45% in the year to June. Heibi is China’s most significant ore producing province and it had to bear the brunt of the tighter environmental policy and its output is down by ~60%. However, in a recent report UBS noted that while the raw output may be down ~40% they estimate that output on a 62%fe basis is broadly stable which implies a substantive lift in the grade of ore produced. Given that if you take the official data on imports and Chinese production at face value it would suggest there has been a significant decline is 62%fe supply in Chinese (of circa –10% year to July) this lift in quality holding up Chinese fe supply would help explain why there has not been a much larger surge in Chinese ore prices.
The new environmental policies have significantly increased operating costs for Chinese miners. As the chart over highlights, despite firm domestic ore prices, the average margin for Chinese iron ore miners has collapsed to a record low of ~2% as operating costs soared. And many of the lower grade and smaller miners, particularly in Hebei but also elsewhere, closed or will soon close because they can’t afford to upgrade their facilities to meet new environmental standards. This will limit the ability of Chinese miners to expand production from here and, in fact, could lead to a further contraction in Chinese output in 2019. We should, however, also note that both the contraction in domestic production and rise in domestic mining cost will continue to support the premium for domestic ore unless the closure of steel mills dependent on domestic ore is enough to reduce the demand for domestic ore offsetting the loss in domestic ore supply.
Imports of ore have also underperformed supporting prices particularly the higher grades.
In the year to July, looking though the monthly volatility Chinese imports of iron ore are best described as flat; in the first quarter of 2018 they were down –3%yr. Rising demand for inputs has supported import prices, relative to the domestic prices, even though the share of imports in total iron supply continues to rise. In the past a rising import share indicated a rising supply of imports and was a negative for imported prices. This time the rising share is in response to a collapse in domestic supply and increasing demand for imports so import prices remain well supported. We also note that the patch of weak imports has also seen the start of the long awaited correction in iron ore inventories at Chinese ports but, at this stage, they are still remain elevated compared to both steel production and the imports – that is import coverage is around cyclical highs.
As noted earlier the spreads, that is the discount/premium applied to the lower/higher grades of ore, have widened. This widening has been driven by administration policies to reform the industry, improve efficiencies and lower environmental externalities. As such, these policies are unlikely to be reversed anytime soon so while the discount/premium may narrow a little over time we expected it to be a very gradual and extended process.
The demand side is expected to ease but supply risks may be more supportive of prices than expected.
We are not on the cusp of an upswing in steel demand from here. Yes, the recent easing in liquidity conditions was a positive but this was in response to the risks presented by the trade tensions with the US rather than a fundamental shift in policy. The Chinese administration has signalled its commitment to manage leverage in the economy and we expect this commitment to be sustained through 2018; 2019; and 2020 as the authorities grapple at diffusing the distortionary impact of the largely unregulated shadow banking system. As we have seen, the authorities will react to sudden slowdown. However, we expect them to accept a gradual slowing to a growth somewhat below current market expectations. Westpac is looking for growth to slow to 5.75% in 2020.
Remembering that 2017 steel production was boosted by EIF closures, Westpac is forecasting steel output to increase by ~5% in 2018 then hold flat in 2019 and 2020. The administration’s focus on reforming the shadow banking sector will limit credit to SOE and regional administrations put a brake on lift in investment. And as the recent upswing in housing activity is more a cyclical restocking than a new structural upswing in property investment its positive impact is set to fade in 2019.
However, iron ore supply will only expand modestly thought 2019 with further declines in domestic production (–7%) while any recovery in imports will be contained by the major miners laser focus on cost control (imports are forecast to grow less than 10% in 2019). This will be enough to drive a modest correction in ore prices (62%fe to fall from an annual average US$85/t in 2018 to US$69/t in 2019) while the discount for 58%fe to hold around 40% in 2019.
That seems to me a very solid base case very similar to my own. The only change I would make is that I do not expect iron ore to rebound beyond 2019. Indeed, as China inexorably chokes on its bad debts, I reckon it is likely to keep on falling all the way down to $20 at some point as Chinese steel output adjusts much lower and scrap production keeps rising.