So when does iron ore go back to $20 per tonne?

Picking up the bat and running with it is GLJ research:

Is it Realistic to Envision an Environment where Iron Ore Prices Drop Back to the 1989-2003 Avg. of $30/MT – i.e., the Pre-China Construction Boom Price?

First off, we’ll remind our readers that from the period of 1998-2003, 62% Fe spot iron ore prices avg.’d $30.17/MT (yes, you heard that right) – Ex. 1.

And, as we learned last week, China’s scrap steel consumption grew by a robust 20.7% y/y in 1H19, to 103.3MMt from 85.6MMt in 1H18 – according to (link) Argus Media’s citation of statistics from the Bureau of International Recycling (BIR).

Importantly, the increase in China’s scrap consumption was attributed to: (a) stricter standards for factory emission that drove China’s basic oxygen furnace (BOF) steel mills to increase their average scrap ratio (i.e., the share of scrap used in the production of new steel) to 21%, and (b) a further increase in steel output from electric arc furnace (EAF) steel mills, with encouragement by the central government — Ex. 2. As we see it, this is further, tangible, proof that a structural shift in steel production is underway in China – one that we believe will lead to a material amount of displaced iron ore demand.

That is to say, earlier this year, we flagged the fact that China’s: (i) crude steel production hit a record high of ~925MMt in 2018, up 7% y/y, based on data from the World Steel Association, yet (ii) apparent iron ore demand declined 6% y/y (i.e., domestic iron ore production was down ~40% in 2018 and seaborne imports were down 1%, based on data from China’s National Bureau of Statistics and Customs Administration) – Ex. 3-5, meaning every ton of steel output was consuming visibly less iron ore – our checks at the time indicated that a higher scrap ratio and strong push toward EAF production capacity were the main culprits for the divergence in steel output and iron ore consumption (i.e., precisely what the BIR conveyed last week). Yet, when taking into consideration China’s: (i) existing target for steel production from EAFs is 15% by 2020, up from 9% in 2018, which compares to the share of EAF production of ~90% in developed economies (namely the US), and (ii) the scrap ratio in BOFs, on avg., of just over 20% in China compared to developed regions of around 30%, we expect the trends singled out in our analysis and BIR’s recent assessment to continue indefinitely.

Admittedly, given the widely-known lack of stable scrap supply for recycling + prohibitive inland transportation costs + quotas that had since driven imports to virtually zero, all of which have sent China’s domestic scrap price to one of the highest in the world, China’s burgeoning EAF vendors are likely to face some hurdles along the way, while its BOF vendors are less incentivized to keep raising the scrap ratio.

However, when considering China generally always protects its industries, as well as the country’s ongoing environmental concerns (i.e., BOF production is notoriously more pollutive than EAF), we suspect the government could soon roll back the scrap import ban and, potentially, add support for inland recyclers. What’s more, giving consideration to apparent steel use per capita in China, which was about 2.4x the world average in 2017 (the most recent data we have from World Steel), as well as an economic slowdown that appears to be gaining steam, we think China’s peak steel demand is likely in the proverbial “rear view mirror”. When also considering Vale’s C1 cost to produce iron ore was $12.4/MT in 3Q18 (i.e., preBrucutu disaster), even at $30/MT 62% Fe iron ore spot prices, we argue Vale would still be “in the green”.

So, what does this all mean for iron ore? In short, we think prices are headed much lower. More specifically, if we assume: (a) YTD steel production of 747MMt (through September) is annualized using seasonal proportions realized in 2018, then China would produce 1,003MMt in 2019, (b) steel output edges down 2% each year (as we think peak demand is upon us), (c) China’s share of EAF production increases from an estimated 10.5% this year to 25% by 2025 (conservative, in our view), and (d) the scrap ratio at Chinese BOFs grows from 21% this year to 27% by 2025, then (at 1.6x crude iron production) China’s iron ore demand would decrease from 1,135MMt in 2019 to 779MMt by 2025, or roughly 6% annually (Ex. 6). Given China imports three-quarters of total seaborne iron ore supply (i.e., 1,064MMt of about 1,440MMt in 2018), on this magnitude of expected structural changes, we posit that seaborne demand could see a roughly 30% hit to demand by the middle of the next decade. At the same time, supply from just the “Big 4” miners (VALE, RIO, BHP, FMG), ignoring the multitude of junior miners, are expected to total 1,200MMt this year, the vast majority of which is destined for China. Therefore, at risk of stating the obvious, we would be aggressively adding to short positions for the long-haul in FMG, RIO, and the greater iron ore complex.

To my mind it is not only possible it is inevitable and foreseeable.

Chinese development is at the crucial point now. If it with continues with reforms to lift its manufacturing base to higher value-added pursuits then steel demand falls throughout the 2020s. Or, it doesn’t, and its growth is bogged down forever into a debt morass that also drags down steel demand as post-reform growth shunts lower to effective zero by 2030.

David Llewellyn-Smith
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