Chinese steel, iron ore and coal
Chinese environmental policies have boosted the demand for higher grades of iron ore but in the long run they may drive a structural shift in demand. Chinese mills are increasingly using scrap steel as its supply grows with more buildings being torn down, more cars crushed and more appliances discarded. A similar shift was seen earlier in the more developed economies. However, there are Chinese characteristics to this trend with the Chinese administration’s focus on cleaning up the steel industry, especially in regards to air pollution, dovetailing with the expanded use of scrap. Using scrap steel reduces demand for coal and iron ore, cuts emissions and produces less solid waste. In addition, scrap can be sourced locally whereas iron ore is now mostly imported – an additional reason for the government to promote scrap consumption.
Recycled steel scrap was the basis for 19.5% of Chinese crude steel output in the first half of 2018, a significant 5ppts jump in the year according to the China Association of Metal Scrap Utilisation. This is a 41% increase in scrap consumption totaling 87.7mtb with Chinese scrap steel prices rising almost 30% in the year. The rising use of scrap represents a clear medium term risk for iron ore demand, and thus prices, with the only limiting factor being the availability of scrap.
Steel output lifted 12.6%yr in September to a new record high of 80.8mt, as Chinese steel mills rushed to get ahead of the winter ‘clean air’ restrictions. This created a bullish environment even as the risks of a slowdown built on the back of moderating infrastructure and construction investment and growing trade tensions. Spot iron ore rallied well clear of US$70/t as the anti-pollution drive added to mills’ margins by shutting down smaller polluting mills. Our iron ore forecasts incorporate this strength continuing until the annual production reset post the Lunar New Year. But scrap may already be impacting on ore demand. Higher grade ore premiums (65%fe and higher) are moderating due in part to falling steel prices. With met coal prices rising, steel mill margins are been squeezed, increasing the attractiveness of cheaper grades of ore. By using scrap, a pure source of iron, mills can increase their use of cheaper, lower grades of ore. So while some of the premium is structural, due to environmental restrictions, the cyclical component, driven by margins, is easing and the use of scrap may be amplifying this. We hold our view for iron ore prices to ease to US$62/t in early 2019 then US$54/t by year end.
Current tightness in metallurgical coal supply could extend into early 2019 due to the persistent vessel queue at Queensland’s Dalrymple Bay coal terminal and the inability of Queensland mines to get enough coal railed to the ports. Our forecast for a correction in met coal is based on the removal of some of these constraints but as time passes, the difficulty in negotiating these issues suggests such a recovery may be delayed. From the demand side, Chinese demand has many moving parts. Chinese port restrictions are hampering the willingness of traders to take seaborne coal, while Chinese domestic coal prices are rising rapidly closing the arbitrage with seaborne coal. Overall this mix can support prices around US$190/t for met coal until supply lifts in 2019, taking prices back down to US$155/t by year end.
Crude oil and LNG
A spike in Brent benchmark prices past US$85/bbl in early October reflected a range of fears around the curtailment of supply. These worries included the upcoming US sanctions imposed on Iran due on November 4, falling production from Venezuela and escalating tensions between the US and Saudi Arabia with the disappearance of journalist Khashoggi. Additionally, bottlenecks in the Permian Basin, the key US oil producing region, further added to the storm of factors that drove up prices. The recent correction over recent weeks to $70/bbl suggests a realisation by markets that these concerns were overdone particularly given rising US inventories and increasing overall supply. Moreover, the downside risks to the global growth outlook with persisting trade tensions also suggest a less rosy picture for demand.
However, ongoing geopolitical tensions remain an upside risk, and will be supportive of prices. A key upside risk is that the waivers granted to major Iranian oil importers expire in six months’ further tightening sanctions Iranian crude supply. Comments from major producers, notably, Saudi Arabia and Russia, suggest limited appetite for major exporters to curtail production with prices near $80/bbl, but equally, warnings by OPEC officials that production cuts could not be ruled out next year suggests discomfort with prices near $70/bbl. Our forecasts over next year are therefore kept within the $70-80 a barrel range. Geopolitical uncertainty remains the key upside risk. However, working in the other direction is a scramble to extend pipeline capacity in the Permian Basin, which should alleviate transportation constraints over the course of 2019.
LNG prices continue to be dragged higher with crude oil in a tight market where increasing demand from China is starting to pull against the current limits on the potential increases in production. Australian LNG exports softened in September to 6.0mt, as forecast by our shipping model, down from the record of 6.26mt in August.
A solid base case.