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Quality takes precedence for Chinese iron ore and steel industry

  • What is driving the significant jump in China’s demand for quality iron ore?
  • Why China’s imports from Australia have increased considerably in the last few quarters despite stable demand?
  • With stringent environmental laws in China, will the spread between high and low-grade ore narrow down?

 

Chinese ports were seen flooded with the steel-making ingredient as its inventory reached an all-time high of ~162 million MT (Q1 2018). The pile-up process that began in early 2016 has not reversed yet. Iron ore inventory at Chinese ports increased from ~95 million MT (Q1 2016) to ~162 million MT (Q1 2018). Ideally, piling of inventory implies falling demand and hence, calls for plummeting prices. However, the current iron ore story is somewhat different.

Iron ore is primarily used for making steel and China being the largest producer of steel is hence the biggest consumer of iron ore too. The incessant increase in iron ore stockpiles (~28%, CAGR, from January 2016 to March 2018) at Chinese ports is not a sign of falling demand as China’s steel production surged by ~4% (CAGR) while the corresponding iron ore consumption increased by ~3% (CAGR) during the same period. Moreover, despite the increasing inventories at Chinese ports, growth in steel demand resulted in higher iron ore prices globally. Prices were additionally supported by bottom fishing from traders, investors and consumers alike after the huge fall during 2014-15 period.

Notably, the backdrop of the current iron ore story is ‘quality of product’ preferred in China. Several years of industrial growth in China has increased the pollution to extreme levels, such that the sky has turned grey in most major cities and blue sky is an unusual sight for inhabitants. The Chinese government has realised the criticality of the situation and has enforced stringent environmental laws. In a recent pollution crackdown, China closed and fined several manufacturing units including numerous mines and steel mills. Hence, in order to adhere to the environmental laws, several steel mills switched to higher-grade iron ore as premium quality ore require less coking coal in the blast furnace and thus, emit less pollution and also boost productivity.

Furthermore, driven by the above shift in requirements, China’s appetite for higher-grade ore (Fe 62% and more) increased over the last 6-8 quarters and that of lower grade (Fe 58% and less) reduced significantly. As a result, price for high quality ore increased during the period. The benchmark iron ore prices for Fe 62% increased from $41 per MT (January 2016) to $63 per MT (April 2018) and touched its peak of $92 per MT (February 2017). On the other hand, prices for Fe 58% increased from $36 to $41 per MT during the same period. Thus, the gap between the prices of these different quality products widened over the timeframe. The spread between the two prices amplified as high as 45% (April 2018) from 13% (beginning of 2016). Additionally, producers of lower-quality ores were forced to offer a huge discount (averaging 37%, Q1 2018) on their products, thereby, further widening the gap.

Primarily, China produces low-quality iron ore, hence, its increased demand for premium quality iron ore was largely met through imports, particularly from Australia and Brazil as these countries produce higher quality products. Australia’s exports to China increased from 198 million MT (Q4 2015) to 218 million MT (Q4 2017), a jump of ~5% (CAGR). During this period, shipments from Port Hedland; Australia’s busiest port (in terms of iron ore loading) surged by ~11% wherein major growth was driven by its exports to China. On the other hand, Brazil witnessed marginal increase of ~1% in exports to China, however, China remained the biggest importer in Brazil.  

Thus, China has been consuming the high-quality imports, while its low-quality produce is hoarded on the ports and this has resulted in considerable amplification in its inventory levels.

While several steel mills switched to better-quality raw material, there were many others that were shut down (mainly inefficient or working on older technology). Notwithstanding, the moderate capacity constraints, the country’s steel production jumped by 5% in 2017, which was the highest since 2014. This was supported by equally healthy demand for steel as economic growth was broadly steady, in turn, leading to significant surge in steel prices. The Hot Rolled Coil (HRC) and Cold Rolled Coil (CRC) prices in China jumped by 21% and 11% respectively (2017) leading to substantial improvement in margins of domestic steel mills. One of the largest steelmakers in the country; Hunan Valin Steel posted a net profit of CNY 4.12 billion (2017) from a loss of CNY 1 billion (2016). Another big player in the country; Baoshan Iron & Steel reported a 38% (YOY) jump in the EBITDA and 111% (YOY) surge in the net profits (2017).

Nevertheless, steel prices have started to drop in 2018, the HRC price was down by 1%, while CRC fell by 4% in H1 2018. Though, the fall is marginal as of now, this downward trend is expected to continue for the rest of 2018 and early 2019, driven by an anticipated slowdown in the Chinese economy. In 2017, substantial growth in China’s real estate market and auto sector (top steel-consuming industries) led to increased demand for iron ore. However, both these sectors and the overall economy are expected to slowdown in 2018-19. Hence, steelmakers’ margins may squeeze down making expensive iron ore less affordable. Although, even if the margins narrow down, steelmakers are not likely to switch back to low-quality as the government is expected to remain stern with its measures to reduce pollution. Tangshan, which is the biggest steel producing city in China has warned the steel mills on a possible curb on production by as much as 50%, in order to meet the emission targets. These units may face closure if they fail to meet the targets by October 2018. Similarly, Beijing aims to expand the crackdown from 28 (currently) to 82 cities.

Therefore, the drive to curb pollution levels is anticipated to outweigh the profitability factor, wherein, major steelmakers will continue to prefer and consume premium quality. Televisory believe that this trend towards consumption of quality material, even at high-prices would continue in the coming quarters. Further, looking at the broader trend for iron ore globally, the commodity might continue to see increasing supplies from major producers in Australia and Brazil as compared to its global consumption and this might lead to stable or subdued trend in prices (both for 62%, 58% and other grades). Nevertheless, the spread between the two benchmark grades Fe 62% and Fe 58% is here to stay as the major consumers in China and other countries continue to demand better quality. The spread has descended moderately since the highs of Dec. 2017 and early 2018 of around $26 per MT and stood around $17 per MT in June 2018. It is forecasted to hover in the range of $15-22 per MT for the rest of 2018 and early 2019, which is way stronger than the past 5-year average.

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