Commodities | Nov 07 2013
-China's steel over-capacity continues
-Chinese sulphur restrictions affect coal
-Iron ore quality also under scrutiny
-Aluminium oversupply to continue
-US/Europe oil market weak
By Eva Brocklehurst
Views have diverged on the steel outlook in China. Macquarie's survey finds traders are more negative but mills are more positive. This divergence was noted at the same time last year so maybe there's an element of seasonality. Steel traders are still seeing orders increase, albeit more slowly, while production is stable and inventory at mills is rising. Mills still plan to increase raw material purchases in the coming months. What is unusual, according to Macquarie, is the strength of construction and infrastructure orders for this time of year. Vehicle sector orders are also healthy and, for the first time in a year, orders from the machinery sector have started to expand.
Overall, the October data points to a steel market that is in better balance than a month ago, with orders still strong and production stabilising. From the raw material aspect, Macquarie maintains the view that expectations of the usual March quarter supply disruptions will drive purchasing decisions over the next few months, possibly at the expense of near-term profitability for the steel mills.
Macquarie has visited the steel mills in Hebei to discuss market conditions and outlook. The most interesting news was the impact of environmental regulations. The broker notes the impact of emission reductions enforced by the government has been real, with production restricted and mills making adjustments to the raw material blends that are driving premiums up for higher quality raw materials. The main focus is on sulphur dioxide emissions and mills were encouraged to install sulphur reducing equipment or risk being forced to shut. The data backs up this impact, as output in Hebei has dropped 16% since peaking in February. The largest share of the adjustment has come from smaller mills. Despite this, steel prices have not been affected, testament to the level of excess capacity.
The mills in Hebei reported significant changes to raw material blends this year. Mills are increasing the share of direct charge iron ores lumps and pellets used in the blast furnace. A typical iron ore blend for the mills last year was 10% lump, 5% pellet and 85% fines, while recently ratios have shifted to 20% lump, 10% pellet and 70% fines. This shift in preference to direct charge iron ores is already being felt in prices. The premium of PB lump over PB fines has risen to $0.25/dmtu from $0.106/dmtu at the start of the year, according to spot price data collected by Mysteel. Similarly, the premium of domestic pellets over domestic concentrates in China has risen to RMB 4.7/dmtu from RMB2.5/dmtu.
Usually this pellet premium correlates well with steel mill margins, as mills are happy to pay a premium for more productive raw materials when they are making money. Macquarie observes the current spike in the pellet premium has occurred at a time when margins have been contracting, which suggests a policy-driven rather than market-driven increase in pellet demand.
Mills are more conscious of the sulphur content of raw materials. This is usually an issue for coal and could result in a higher proportion of better quality coking coals, a reversal of the trend seen in recent years. What the exact policy is is yet to be determined as guidance has been confusing to date. A mooted policy of banning mills from using coking coals with sulphur above 0.6% was deemed unfeasible by the mills that Macquarie visited. Even the highest quality emanating from Australia has sulphur content of 0.5-0.6%.
What surprised the analysts was that mills are also becoming more sensitive to the sulphur level in iron ore and are reducing the volumes bought from Mexico and Chile. Overall, environmental restrictions are positive for higher grades and direct charge ores. Should the constraints reduce effective capacity, mills could recover some pricing power and exports from China would be reduced if domestic prices rose. So far the level of excess capacity is sufficient to allow rising exports as well as a reduction in Hebei output, without any margin recovery of note.
Global production of aluminium in September was at its third highest monthly level ever according to the International Aluminium Institute data. There was an additional 558,000 tonnes of annualised production against August levels, equivalent to a growth rate of 5%. This increase has come despite calls for greater producer discipline and the need for production cuts to obtain a semblance of balance. Citi observes that, despite continued talk of measures to restrict smelter capacity growth in China, production continues to surge. Annualised Chinese aluminium production reached 25 million tonnes in September and, according to the Chinese government, around 100mt of new capacity is being built. Moreover, around 1.2mt of this capacity will start up in Xinjiang before the end of the year.
Just looking at primary aluminium trade statistics would suggest that China is a net importer of primary aluminium, but Citi believes that much of the imports are high purity aluminium for the aerospace sector, rather than more common LME grade 99.7 spec metal. Taking note purely of primary trades is a major analytical error, in the analysts' view, as this doesn't provide a true picture of China's actual aluminium balance. Citi retains the belief that the Chinese aluminium market is, at a primary level, in significant surplus, and is forecasting over-production of 1.3mt in 2013.
So, the rest of the world is cutting production but it's likely not enough. There's also growth in other regions besides China. Production in the Middle East has grown 6.6% year to date. Moreover, the strong financing demand for aluminium it suggests to Citi that the extent of oversupply will continue, despite much publicised cuts form Alcoa and Rusal. Citi expects a global aluminium surplus of 775,000 tonnes in 2013 and the market to remain in surplus for at least the next three years.
Oil markets in the US and Europe are substantially weak. North Sea weakness is notable. Citi observes that seasonality points to a rise demand into the year end and CFTC data shows a reduction in non-commercial net length across the oil complex, which should support the market. The US is increasing export volumes and, as a result, exporting margin weakness into Europe. Citi expects West Texas Intermediate to rally against Brent in the coming months but there is no sign of strength in the US market, with a range of crudes revealing weak pricing. Refiners are running down inventory into the end of year for tax reasons and this may be starting to weigh. Meanwhile non-OPEC supply growth continues apace.
European crude product markets are under pressure. Citi observes that US product export capacity is not constrained and distillate exports to Europe are expected to reach new highs this winter. Milder weather is not helping demand for heating at a time when demand is soft. Despite milder weather in Europe, the reliance of winter supply on imported gas, given declining domestic production and lower storage levels, is expected to underpin prices.
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