When will iron ore follow supply and demand economics

A bit of basics with respect to supply, demand and prices:

• All other things being equal, if demand for X remains flat and supply of X is curtailed, the price of X rises as consumers bid up for X.
• It follows that, if supply of Y remains flat and demand for Y falls, the price of Y decreases as producers of Y chase down buyers of Y.

Now let’s replace X with “steel” and Y with “iron ore - IO”.

China is the world’s biggest producer of steel (approx 800 mio tons/year – 50% of global output). On the other hand, China only accounts for 15% of the world IO production (basis 62% Fe content of course – so 325 mio tons).

It is therefore not surprising for Chinese steel prices to rise as the government and local authorities are shutting down steel production capacity within the scope of a broad effort to fight pollution.

Less intuitive is to see IO prices rise in tandem and keep following marginal gains in steel prices.

Government policy

China is fighting for the number one spot across all areas. Unfortunately, this also includes the not-so-attractive title of number one polluter. Over the years, the central government and local authorities have made serious efforts to tackle this.

To start with, they looked at thermal coal power generation: power plants have been moved, efficiency has been improved and the use of poor quality fuel has been banned. Now focus is on the steel industry and drastic measures have been taken.

As far as the Hebei province is concerned (which basically surrounds the municipality of Beijing and also includes the area of Tangshan – China’s biggest steel production region), the following cuts are scheduled to run through to mid-March:

• 25.55 mio tons of steel production
• 20.66 mio tons of iron making

Additional cuts have been have been implemented sporadically to meet environmental targets when adverse weather conditions are expected. This was namely the case between November 25 and November 28 as well as between December 1 and December 4.

Impact on steel and IO prices

As mentioned above, assuming steel demand remains flat, a reduction in steel production should translate into higher steel prices. If inventories are low (indeed the case right now in China with a mere 20 mio tons or 5 days of average sales by distributors at the start of November), steel prices can overshoot.

But lower steel production means lower IO consumption and – therefore – lower IO demand. You would therefore expect IO prices to come off.

This even more so given that IO inventories are more than comfortable: port inventories are at approx 140 mio tons  (approx 35 days utilization) and there are additional stocks at mills (for an additional 20 days utilization). 

On the other hand, it can be argued that domestic IO production has also been cut. Fact is, more steel production has been shut than iron making. Moreover, considering approx 1.6 tons of IO are needed to produce 1 ton of steel, these measures are clearly leading to an excess of domestic IO supply.

Last but not least, China’s current IO mine ‘utilization’ is at approx 50% so there is obviously room to catch up elsewhere.

So, in a nutshell there are no significant mitigating factors to justify IO not coming off.

The fight for quality – higher Fe content

Over the past 18 months, the IO market has experienced a continued divergence between the price for 62% Fe content material and lower grades. This preference for higher-grade iron ore represents a structural shift in the IO market. Indeed, given China’s weight in the global IO market and its commitment to environmental policies, Chinese steel mills will need to use the highest purity iron ore:

(1) Using low Fe content material (ie: domestic production) requires extensive sintering with coke to improve quality prior injection in a blast furnace, which is a polluting and energy-intensive process. Considering that coke (itself obtained by processing coking coal) is extremely expensive (coking coal is again trading well above the 200 USD/t mark), focusing on high Fe content IO is now imperative.

(2) In a situation of high steel prices and tight capacity, every ton counts meaning that mills will opt for higher-purity iron ore that increases blast furnace efficiency.

That suits Beijing as it reduces pollution per ton of steel produced but is bad news – in the long run – for iron ore demand if we focus on tons rather than total Fe content.

On a different note, this explains why companies like Fortescue (producing 56% Fe content material only) are being outperformed by peers as they only capture 70% of the iron ore reference price.

What’s next ?

China’s recent IO imports have been on a roller-coaster: 102.8 mio tons in September, down to 79.49 in October (the lowest since Feb 2016) and then back up to 94.54 in November. It's obviously not straight forward to draw conclusions from these numbers although the November figure surprised to the upside. Although port inventories are up approx 10 mio tons from mid October, more data is needed.

A downside risk for IO prices in the short run lies in the seasonal increase in throughput to be expected by miners at the end of the calendar year (aiming at maximizing profit and off-load tons from the balance sheet) and the opposite by consumers and traders.

Conclusion

There is obviously a correlation between IO and steel prices – especially in China, the largest steel producer and largest consumer/importer of IO.

If you shut steel capacity, it means that you produce less steel. If demand for steel is unchanged, it makes sense for steel prices to rise – even sharply if inventories are low. But it doesn’t make a lot of sense for IO to rise. 

All other things being equal, steel and IO production cuts in China should skew the market towards a net reduction in IO demand - especially taking Fe content into consideration.

Will the steel capacity put on hold by China come back in April next year ? Given what has happened with thermal coal generation capacity in the past, this is not a done deal. If the government believes that the contribution of these cuts on pollution and the environment have been positive, these measures may turn permanent. It’s also worth wondering if these facilities can actually be turned back on – technically.

At the moment, with no weather related supply shock on the horizon, the availability of high grade IO from Brazil (Vale) and Australia (BHP and Rio) should be more than comfortable. The only major not planning to increase production is Fortescue – whom, as mentioned above, is actually producing 56% Fe content material and should/could actually consider diversifying away from IO.

Goldman recently published its forecast for IO prices: 60 USD/t in 3 months, 55 USD/t in 6 months and 50 USD/t in 1 year.

This compares to approx 70 USD/t spot and forwards at 69, 66 and 64 USD/t for respectively Q1, Q2 and Q4 18.

The spread between 62%+ Fe content IO and lower grade material is more difficult to trade and would probably require equity positions.