For How Long Can Iron Ore Defy Gravity?

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

Iron ore prices have rallied as Chinese steel consumption has surprised to the upside. Will the heady prices last?

-Steel prices remain strong and likely to support iron ore pricing in the first half of 2017
-However, iron ore prices unlikely to defy the fundamentals forever
-First danger period for iron ore prices expected in late northern summer
 

By Eva Brocklehurst

Iron ore prices are in the spotlight. Chinese steel consumption has surprised on the upside, as have Chinese steel prices. Steel producer margins are high and forward order book expectations are rising. Brokers believe this is a factor that has driven iron ore prices well above expectations.

Heading into seasonally strong demand, Credit Suisse does not expect that steel prices will give way, just yet. The broker believes steel prices can support a US$90/tonne iron ore price throughout the first half of 2017. Credit Suisse raises its FY17 earnings estimates for BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)) by 8%, 34% and 20% respectively. The broker upgrades Fortescue Metals to Outperform.

Credit Suisse observes the surge in the iron ore price has left clients wondering whether now is time to exit the sector. The broker's initial suspicion is that it's too early, because this is a demand story and the iron ore price is tracking Chinese steel rather than its own fundamentals. Moreover, the construction season, with peak steel demand, is yet to come.

Still, supplies are more than adequate and iron ore is not expected to defy fundamentals forever. If soft demand, as construction eases, causes an extended slide in the steel price then the broker suspects a buyers' strike on iron ore cargoes is likely. This would lead to a rapid unwinding of the iron ore price, as steel mills worry about margin compression and become wary of the risks in bidding for spot cargo.

In the September quarter, the typical rebound in construction is expected and iron ore prices could be volatile albeit generally lower than the first half. Credit Suisse forecasts US$70/t.

UBS observes sentiment remains the key driver of price. This is positive in the short term, underpinned by infrastructure, property projects and government policy. Chinese mills are showing greater interest in high-grade iron ore, because of the high price of metallurgical coal. As a result, low-grade material and lump is building at the ports.

The broker believes the spot price of US$90/t is unsustainable, and risks a lift in supply. Nevertheless, seasonal demand and high Chinese steel prices and margins should support the price at around US$80/t throughout the first half, before UBS forecasts it to ease to US$60/t in the December quarter.

Credit Suisse agrees in that, while there is still too much iron ore supply, this is not the focus of steel mills and traders right now. They want to re-stock and want higher grades and are willing to pay, given steel margins are wide and there is plenty of room at the ports. This is not to say that ignoring iron ore supply will continue to be a feature of the market.

The first danger period for iron ore prices will be the late northern summer, when heat slows construction in China, Credit Suisse believes. The broker's forecasts still indicate oversupply for iron ore of 50mt across 2017. A lower price is suspected to be the trigger at some point in the year to force mine closures. Credit Suisse forecasts US$55/t in the December quarter.

The broker continues to expect 3% growth in Chinese steel demand in 2017 but considers a sharp spike in steel pricing unlikely. While infrastructure and housing construction are lifting demand, this is a clearly different rate to the frenetic pace of construction that occurred prior to the global financial crisis.

In 2018, the broker expects a slowing down of infrastructure projects and this may cut demand by -1-2%. Nevertheless, this does not support a price collapse for steel or iron ore, just signals 2018 should be weaker than 2017.

Shipping Rates

A significant decline in Western Australian iron ore shipping rates during January and February probably also contributed to the recent strength in iron ore prices, Macquarie contends. While shipping rates have started to recover, the wet season is not over and the risk of supply interruptions remains. Based on guidance by the major Pilbara iron or producers, a normal wet season would mean the shipping rate is around 780-810mtpa, which is broadly in line with the January and February averages.

Macquarie notes steel mill margins continue to improve, helped in some degree by the easing of coking (metallurgical) coal prices in recent months. Chinese steel output traditionally rises strongly from March through to May, peaking in May or June before steadying over the second half.

Inventory build has been minimal, despite the optimistic outlook for orders, and this optimism is probably better reflected in steel trader inventory, Macquarie asserts. Trader inventory levels are at their highest in nearly three years. Credit Suisse also makes the point that stocks at the ports are growing at the same time as shipments from Brazil and Australia are relatively weak.

Will China's Mines Re-start?

UBS notes that Chinese iron ore miners appear reluctant to re-start operations because of the cost, as well as being sceptical regarding the sustainability of high iron ore prices. Yet, with a stronger price, there remains a risk that domestic output will rise. Credit Suisse cites a common estimate for domestic mine costs of US$70-80/t and, as the iron price has now exceeded this, this brings a risk of re-starts.

What is less clear is whether there are any operations that are suitable for re-starting. The broker notes no one is sure how many were dismantled, had permits forfeited or are just left in decline. The broker believes there is a need to watch future data regarding capacity utilisation, and whether this lifts above the recent high of 65.7%, noted back in November.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms