The ferrous complex dead cat bounced on August 20, 2021 with spot and paper up. Steel has not updated.

Westpac says it better than I can in a new note:

Iron ore – are we there yet?

Back in February we asked the question, “when will the iron ore prices fall below $130?”. At the time we answered the question somewhat cryptically by stating that “prices will head lower once demand and supply dynamics normalise – with a move back to $105 to $130 being our target”.

Now, with the benefit of hindsight, we could have answered simply August 2021. But the point we were trying to make at the time was that we were seeing super strong Chinese steel production driving super strong Chinese iron ore imports; but this was being met by limited growth in supply from Australia and Brazil. In that situation, it was no surprise that hit iron ore prices hit and maintained records as long as they did and indeed pushed much higher than we expected through Q2.

However, more recently, our confidence has been building that those demand and supply dynamics have indeed begun normalising. Chinese steel production in June and July for example fell well short of expectations – July especially so.

Waning steel production means falling iron ore imports into China, and this has been very obvious in the last couple of months data as well. Chinese imports of iron ore hit 16m lows in July. On top of this, exports from both Brazil and Australia have been rising in recent months too. On the basis of our shipping activity models, combined Brazil and Australia iron ore exports hit 7-month highs in July.

This can be seen even more clearly when we look at the monthly seasonals with combined Australian and Brazilian exports more than 1 standard deviation above the 5-year seasonal norm while Chinese imports fell below the 5yr average in July.

As we highlighted in our last “Bulks Update“, unseasonal maintenance has played a really important role here in Australia too. Rio noted in its June quarterly production report “we successfully completed a planned five-week maintenance shut at one of our four port terminals, East Intercourse Island (EII), slightly ahead of plan”.

That suggested to us that export volumes were set to recover from the 16m low from Port Dampier in June; and that is indeed the case according to our shipping activity models which highlight a solid bounce back in July and August.

However, BHP also noted in its quarterly production report “a major maintenance campaign on car dumper one planned for the September 2021 quarter”. That suggests that volumes from Port Hedland could slow in coming months. And that does appear to have constrained overall exports in August so far. However, even if we take exports for the first half of August and gross up for the full month, total August Australian exports are still up 1%yy suggesting the trend of modest growth remains.

The straws that broke iron ore?

So, if Australian export volumes have risen, but not materially, what was the straw that broke iron ore this week? Our sense is that it is expectations of a potentially sharp correction in steel production in China that drove the sharp moves. There are three reasons for this.

Firstly, China’s ‘blue skies policy’ has forced increasingly strong environmental constraints on steel production, sintering etc. And with the 2022 Beijing Winter Olympics being hosted close to steel making regions, these constraints will rise as we move through the end of this year. Recent press has confirmed that production cuts in the Tangshan region will be extended through to March 2022!

Secondly, President Xi’s “common prosperity” plan was reported to have been revealed to a high-level party meeting on Tuesday this week with the Central Committee for Financial and Economic Affairs calling for high income groups to “give back to society more”. Talk that a property tax will soon be revealed added to the hit to iron ore prices over the last few days.

Thirdly, and in the background, in December last year, the Ministry of Industry and Information Technology (MIIT) released a ‘discussion’ paper titled “Promoting the High-Quality Development of the Iron and Steel Industry” which argued that for the iron and steel industry to be able to meet its obligations under the 14th 5yr plan, the following will be required:

• Increase China’s self-sufficiency for ferrous content to above 45% by increasing scrap output to 300mmt and ownership of Chinese controlled foreign mines to rise to 20% of import volumes.
• Improve the ability to guarantee resources by making full use of both domestic and international resources. Promote large scale overseas Chinese consortium owned iron ore mines in West Africa and WA and strengthen project cooperation in Russia, Myanmar, Kazakhstan and Mongolia.
• Increase Electric Arc Furnace (EAF) output to be increased to 20% share of total domestic crude steel output.
• Increase the capacity of advanced coke ovens to above 70% and advanced steel production to 80% of the total.
• The steel industry to install ultra-low emission technology on 80% of capacity, and 100% in key areas; and emissions to fall by 20%
• Steel industry consolidation with the 5 largest companies accounting for 40% of production and the top 10 a total of 60%
• Improve labour productivity to 1,200t per capita and 2,000mt steel per capita for new units.
• Steel capacity swaps to be tightened to 1.5:1 from 1.25:1 in the Beijing/ Tianjin/ Hebei region (1.5mt of capacity needs to be closed for 1mt new capacity elsewhere) but will stay at 1.25:1 in the rest of the country.
• Strictly enforce capacity caps and utilise new technologies including satellite monitoring.
• Develop EAF technology to fulfil green and low carbon market regulation.

We tend to see the first two factors as very much working hand in hand with the third, the strategy of promoting the high-quality development of the steel industry. China produced over 1bn tons of steel in in 2020. In the year to July 2021, it has produced 645mt. If it is to meet the target of capping steel production at 2020 levels, production will need to be on average 11% lower in each month of the rest of this year!

Supply, demand or both?

However, it’s not just the steel production side that has led to the correction. As above, we have seen steel production falling; iron ore imports falling; scrap imports rising; Australian and Brazilian exports rising. And we see all of those factors as playing a role.

To bring all these factors together, we have developed a supply/ demand model that derives ‘fair value’ for iron ore from Chinese steel production, Chinese iron ore imports, Chinese scrap imports, Australian exports and Brazilian exports (all seasonally adjusted in log of levels with lags).

As you would expect, the model output below points to iron ore prices having been well above fair value for 7 of the last 8 months. As we argued in February, we put this down to buyers being ‘forced’ to pay super normal prices to secure supply, in the face of high steel mill profitability.

However, in the last 5 months, that measure of fair value has fallen by a hefty 35% adding to the rising risks of a sharp correction. And now that steel production is being more forcibly capped, iron ore prices simply ‘had to’ return to ‘more normal’ levels.

Now, as of July, the upper half of the forecast range for this model was $100 to $125, suggesting that iron ore prices could fall slightly further before we reach our ‘equilibrium levels’.

Beyond that, it’s very much down to the above key drivers – Chinese steel production; Chinese iron ore imports, scrap imports and domestic iron ore production; plus both Australian and Brazilian iron ore exports.

Key for us will be Chinese steel production, and if caps are enforced, we suspect the correction may have further to run later this year.

Are we there yet? Probably not.