More reasons to be bearish iron ore

Via GLJ research:

Iron Ore Prices Have Been Getting Battered Lately, at a Time When Seasonal and Cyclical Factors Suggest Prices Should Be Seeing Some Support; but, Given an Array of Company Production Updates + Trends in Seaborne Imports + Structural Changes in Chinese Steel Production, We Believe we Understand

Why Prices Are “Bucking the System”. Over the past month, spot prices for the benchmark 62% Fe fines iron ore were down 13%, while prices for the active futures contract traded on the SGX were down 14% over the same timeframe; from their peaks observed over the summer, prices were down 31% and 36%, respectively (Ex. 1).

Interestingly, this recent sharp, downward price pressure is occurring at the time of: (i) a weaker dollar, prompted by central bank easing (i.e., the CNY/USD is -2% m/m; we single out the CNY given China accounts for ~75% of seaborne iron ore demand), and (ii) what is typically seasonal restocking of iron ore inventory by Chinese steel mills (this generally picks up through November and peaks in December), both of which should ostensibly provide support to iron ore prices. So, what could be driving prices lower at this time? In our opinion, we think the accentuated price declines of late are a function of: (a) updates to guidance and production roadmaps provided by the world’s biggest, publicly-traded mining companies via recently available quarterly production reports, investor decks, and press releases (where supply is expected to surge in 2020), (b) iron ore imports into China that are trending down y/y on a YTD basis (indeed imports surged in August and September), implying waning demand, and (c)
our view that Chinese iron ore demand has likely peaked (due to an accelerating shift towards electric steel furnaces and higher scrap ratios used in blast furnaces).

Let’s assess each of these points in further detail. First, looking at the “Big 4” iron ore producers (RIO, VALE, BHP, and FMG), we find that production/shipments for 2019/ F2020 is expected to total 1.1MMt, a decrease of 4% y/y on account of lost production at VALE (due to its Brumadinho mine collapse last January) and RIO’s lowered sales guidance caused by Cyclone Veronica back in April (Ex. 2).

Partially offsetting this lower output is an increase from Anglo of ~17MMt this year, +37% y/y, enabled by the return of Minas Rio. Yet, following updates from 3Q19 quarterly production reports + recent investor decks and press releases, we expect an incremental 131MMt to come online over the next couple of years, the bulk of which will come online in 2020, including (a) 60MMt of resumed/ramped production from VALE (Ex. 3), (b) ~35MMt from RIO’s ramp up to 360MMt (link), (c) ~30MMt from the restart of Samarco (link), and (d) another 6MMt of 65% Fe-content ore from Tacora’s Scully mine inWabush (to name just one of the junior miners out there). When adding in ~64MMt of production from AAL and 20MMt annually from CLF, we find that total iron ore supply from the Big 4 miners + AAL/CLF + only one junior miner should exceed 1,310MMt by 2021, +11% from 2019/F2020, versus aggregate seaborne demand of ~1,462MMt in 2018. Against this backdrop, to our second point, China’s iron ore imports YTD are down 2.2% y/y, even when considering the surge witnessed over the last few months (Ex. 4); when also accounting for the 9% y/y increase in domestic iron ore production, we find China’s apparent iron ore demand YTD is down 1.3% y/y (Ex. 5).

Finally, to our third point, 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 citation of statistics from the Bureau of International Recycling (BIR). As we have argued for over a year, this is attributed to: (a) stricter standards for factory emissions 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. In our opinion, this is 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 (i.e., we think China’s iron ore demand may have already peaked). Resultantly, we believe seaborne iron ore supply could easily exceed demand from 2020 onward, implying prices will suffer.

David Llewellyn-Smith
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