Commodities | Aug 28 2012
By Greg Peel
“Our conversation with [Chinese] traders and steel mills suggest that the iron ore price could dive to US$90/t,” said Citi, two weeks ago. At that point the price was still around US$110/t, and today it is at US$99.50/t. Citi is not alone in fearing a US$90/t price.
Were the price to hit 90, it would represent a 50% fall from last year's peak at around 180, and a 133% fall from the 2008 peak of around 210. Oh how the mighty have fallen. The problem, unsurprisingly, is China.
Clearly Europe is the biggest drag on the global economy at present, while the US is bungling along. Both are major customers for Chinese exports, so clearly China's export industries are in the doldrums. However, China's domestic housing market represents 60% of the country's steel demand, so it is domestic heavy industry rather than the export economy which is impacting most heavily on steel, and thus iron ore and coking coal prices. Exacerbating the issue is China's juxtaposed capitalist/communist structure.
In a capitalist world, reduced demand for steel would encourage mills to back off on production, and force higher-cost mills to shut down. A steel price floor would thus be established, and that floor would flow through to floors in steelmaking's inputs of iron ore and coking coal. But as ANZ Research notes, Chinese steel mills are not responding to the market signal of falling prices and continue to operate at near record-high production levels. The industry, dominated by state-owned enterprises, is very much motivated by political and social drivers, ANZ suggests, including employment and provincial tax revenues.
While steel prices are falling, the situation is actually worse for iron ore prices. History suggests a positive correlation between steel and iron ore prices of 1:2, and since May ANZ notes Chinese steel rebar prices have fallen 18% and spot iron ore has fallen 33%. At today's price, under US$100/t, some 50% of Chinese domestic iron ore supply is losing money, ANZ believes. For any floor to be found in the price, supply must begin to be wound back.
Morgan Stanley believes the spot price for 62% iron ore fines could have 7-16% further downside from the current level of US$99.50/t (cfr North China), and that hard coking prices could have 5-8% further downside from the current level of US$163.50/t (fob North Qld). Chinese rebar and hot rolled coil (HRC) steel prices have continued to fall, reaching a 33-month low last week. Deutsche Bank believes panic has now set in for Chinese ore traders for fear of being caught long as prices accelerate to the downside. Since the breach of U$100/t, many participants on the sidelines are now waiting for a bottom to become evident before buying.
Aside from the aforementioned socialist explanations as to why Chinese steelmakers blindly push on to record production despite falling demand, analysts also acknowledge the long-held expectation Beijing will act in the second half of 2012 to curb China's slowing economy with decisive monetary policy action. This belief has not simply been held by rest-of-the-world economists and commodities analysts, but by the Chinese as well.
Westpac suspects China's heavy industry sector and metal traders attempted to front-run a move toward a more stimulatory policy setting but were left both overwhelmed and overstocked as the Chinese economy continued to slow without any big guns being fired from Beijing. Deutsche cites evidence of the entire pipeline of inventory within China – from raw materials to semi-finished goods to finished goods – being “incredibly” full in suggesting the industry has been misreading government stimulus measures which have disappointed. In 2008 the Chinese slowdown was sudden and so was the industry response. In 2012 the Chinese slowdown has been a slow grind by comparison, resulting in a slow and reluctant response from industry.
The iron ore price has fallen, RBS Australia summarises, on weak steel prices, steel production in excess of demand, rising producer inventories and no consumer confidence in the trading price of iron ore next week, let alone next month. RBS believes evidence of stimulus sufficient to halt Chinese steel stock build-ups and to facilitate an orderly destocking phase will be required before a genuine return of confidence is apparent. Steelmakers running at a loss have been forced to destock their iron ore and coking coal, notes Macquarie, but in no orderly fashion.
Who wants to catch the falling knife?
The answer to that question might just be Deutsche Bank. “We are reluctant to wait for the inevitable scramble for cheap iron ore units that is likely over the next month in our view,” say the Deutsche metal analysts. “While we acknowledge the poor condition of Chinese steel, and consequently iron ore, we believe that is starting to be fully factored in and advocate investors (in iron ore contracts) begin to build long positions below the US$90/t level.
As iron ore prices fall, Deutsche expects steel producers to likely switch away from buying expensive lower quality domestic iron ore to the superior and attractively priced imported ores. The analysts also expect a supply response from high-cost domestic miners within China as margins go cash-negative, which should help to support the market over the next quarter.
Macquarie recently surveyed Chinese property developers. The results were “very disappointing” because things were improving but now they have taken a sharp leg down. Having said that, while conditions do remain very weak right now the Macquarie analysts do think we are getting close to the bottom of the cycle. The December quarter should see a seasonal uplift in demand and infrastructure spending is starting to come through the economy.
UBS is also putting its faith in the conventional seasonal uplift in trade in the December quarter. “We are increasingly bullish on iron ore's very short-term outlook,” the UBS analysts said last week, “for there is no obvious impairment of Asia's steel industry”.
Morgan Stanley also supports the view raw material prices can recover in the fourth quarter, but spot prices for both iron ore and coking coal still have to fall below the marginal cost of the seaborne (not Chinese) market to drive out the short-term supply overhang, the analysts suggest. Furthermore, Chinese steel mills have to complete finished product and raw material destocking to stabilize both steel and raw material prices, the analysts believe, and a stimulus-driven demand recovery has to trigger a restocking cycle.
Steel prices, which are currently near GFC lows, may have overshot to the downside, ANZ suggests. The analysts see risk of a relief rally once the dust settles. But with steel mills not yet reining in production in a response to lower prices there is a risk of a supply overhang as we enter the seasonally stronger fourth quarter.
The slowdown in housing, shipbuilding and manufacturing in China has added to steel price weakness, ANZ notes. Allocated government spending in real estate, with which Beijing is undertaking state-run social housing development as a counter to runaway speculative private sector development, was behind schedule in the first five months of 2012, with only 25% of earmarked funds spent. That run-rate has picked up in the past two months, ANZ reveals, with 52% of the expenditure bill rolled out.
There is another problem however, and that is one of the upcoming ten-year political changeover at the beginning of next year. Government policy tools are likely to be ineffective, ANZ suggests, until wider ministerial positions are confirmed in December. On that note, and considering the importance of the housing market to steel demand, ANZ does not expect activity to turn more positive until the June quarter 2013 as new government policy initiatives start to roll in.
Citi disagrees. “Some investors are hoping for a boost after an investment rush post the power change,” note the Citi analysts. “We believe headline news may trigger a short rebound [in Chinese steelmaker stock prices], however stocks look overvalued if we write off book value with potential losses to be incurred in 2012”. Fire sales of Chinese inventory should drive down steel prices further from today's levels, Citi believes, as highly leveraged traders go bankrupt and banks become more prudent on steel trade financing. Trader destocking could finish by year-end and restocking might happen prior to Chinese New Year, but the Citi analysts are not prepared to bet the house.
Citi does not expect to see a big rally in the December quarter and see excess capacity becoming more excessive, capping the upside for a seasonal rebound.
The conclusion appears to be that things must first get worse before they get better. A shake-out is required which would put a floor in place, but expectations of a typical December quarter rebound might just be ambitious at this point, all things considered.
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