Wednesday 16 March 2016
Iron ore rising: why the rally won’t be sustained
Wednesday 16 March 2016
There has been a significant rally in the price of iron ore and very recently, significant volatility, with the bulk price rising ~70% from mid-January 2016 to hit $63.7 a dry metric ton in March. We investigate whether this recent trend is just short term volatility or a balancing of the supply demand equation.
The recipe to get a 20% lift in iron ore prices – What’s been happening?
- Liquidity – Like any good recipe this one begins with policy support. The Chinese government turned on the liquidity taps in January. Who were the recipients of these loans? Loss making “old economy industries” aka steel. While this flies in stark contrast to proposed supply side reforms there is only so much pain the economy can take. This was an effort to avert a spike in defaults/shutdowns as repayment pressure peaks over the January period.
Chart 1: Chinese Social Financing
- Re-stocking – Let’s imagine you own a steel mill in Ma’anshan that has had a negative return on equity for the past five years. Construction season is coming up, steel traders are restocking and the steel price is showing signs of life. You have just been handed a cheque from the local state owned bank. What do you do? We think, you buy iron ore. Chinese steel mills are buying iron ore to produce more steel in anticipation of higher prices.
In the context of Chinese iron ore imports –which are currently running at around 80mt per month, the extra demand is equivalent to ~10 days of imports. It’s important to note that there is no flexibility in these production volumes for seaborne producers – they are running flat out to gain fixed cost/scale advantages. There is no short term supply elasticity (i.e. supply cannot react quickly enough) – so prices are likely to rise fast.
Chart 2: Chinese Iron ore inventory levels
- Supply – Against a short term stocking event, supply does not matter. That said, shipments so far this year have been weak relative to history and market expectations –mostly due to inclement weather in WA.
How does the recipe look longer term?
We think restocking is seasonal – underlying demand and supply is what matters.
- Demand. As we have talked about previously there are two main sectors from which this will come – infrastructure and property.
- Infrastructure: Controlled by government and is likely to grow at a similar pace to last year. We don’t believe China’s balance sheet allows it to splurge 2008-style and the spending is now at a much larger base level.
- Property: Inventory overhang remains a huge issue and we expect this to persist for the next 12-18 months.
- Supply. Supply from large players who have already spent the capex is coming - this is likely to lead to continued supply pressures and does not bode well over a longer time frame as you can see from the chart on the left.
Chart 3 and 4: Iron Ore Supply and demand (annually and quarterly)
Source: Worldsteel, company data, customs data, Mysteel
Key indicators we will be looking at over the next few weeks
- Demand: The billion dollar question – will there be any real pull through in demand for Chinese steel? Property, construction & infrastructure data points will be the key indicators. Sustained strength in domestic steel prices will also be important as a “real time” demand indicator.
- Supply: We will be tracking weekly shipping volumes out of the Pilbara and Brazil like a hawk.
In light of this, we think the longer term outlook for Iron Ore is still poor.