The transition in China is underway. A country where economic growth has been built on infrastructure and residential construction is now trying to resemble that of the Western world where the consumer and services dominate. No longer can China rely on stimulating heavy construction to drive growth. Commodity demand is waning and the capacity created in manufacturing by China, as it grew from the early 2000s, now looks to have been overly optimistic.

Despite claims from many mining companies that peak steel consumption has yet to be reached, China and its steel industry tells a different story. The only debate is whether it peaked in 2013 or 2014. It isn’t just words that are telling us that the glory days for Chinese steel are over but the earnings (or lack of). While red is a lucky colour in China, the sea of red plaguing the steel industry is anything but, with the fall in East Asia imported hot-rolled coil (HRC) prices and steel spreads accelerating over the past 12 months (see figure 1). Luck is certainly not shining on many miners at present who have built out capacity in anticipation of strengthening demand, only for their projects to be completed just as demand for their products begins to subside.

The environment could be the lucky one

The Beijing Air Quality Index (AQI) has risen to over 15x the healthy limit in the past weeks with level 3 alerts (out of 4 levels) commonplace. The steel sector struggles to generate any cash and is likely to draw the ire of the central government, which is acutely aware of the environmental impact of heavy industries on the health of its citizens. The pollution level is the equivalent of smoking 40 cigarettes per day for those living in Beijing.

This is a delicate balance for the Chinese economy and policy makers. The government must balance economic growth goals of 6.5–7% p.a. with the needs of their people, from both an employment and a health and well-being standpoint. China is changing its focus on improving the environment and the lives of the domestic population. The tone has been obvious from Beijing and the anti-corruption drive of the past 18 months has impacted not just corruption but project approvals and infrastructure development.

Demographic crisis

While all this has been happening, demographics have shifted unfavourably. China is facing a crisis within its population. The consequences of the One Child Policy introduced in 1978 are playing out and are likely to impact the real estate market more heavily. The key buying age group in China according to real estate company, Century 21 is the 20-30 age bracket. The decline in this population since the 1980s is stark and provides some concern for the residential property market.

The number of children born in the 1990s was 24% lower than the number born in the 1980s. More concerning, is that the number born in the 2000s was 36% lower than the 1980s. This has forced the relaxation of the One Child Policy this year, but China is facing a situation eerily similar to Japan with the consequences of limited economic growth considerably more consequential to the world economy than the slowdown in Japan in the 1980s.

The Chinese government does, however, have aces up its sleeve. One of the benefits of a communist economy is its ability to control the transition. The government is likely to shift the stimulus focus towards consumer spending and individual wealth generation. A strong and robust secondary real estate market is essential for creating wealth. This is evidenced in Tier 1 and 2 cities like Beijing and Shanghai.

Existing home sales in Tier 1 cities now represent 70% of all sales, and the mid- to high-single digit annual price growth is an encouraging sign of increased wealth. This is likely to result in a rise in renovations, typical of what we see in the Western world. Companies exposed to renovations, as opposed to the raw materials for new housing construction, are likely to outperform in these types of environments. Paint, bathroom and kitchen fitting, electronics and furniture suppliers are all likely to prosper over the medium term as this area of the economy grows.

What is clear, however, is that the residential construction market, which once represented 20-25% of GDP, is no longer growing. Residential construction is expected to be a drag on economic growth in 2016 reflecting the collapse in property markets in Tier 3 and 4 cities. This is the heartland of Chinese manufacturing where we are likely to see closures of heavy industry, such as steel and aluminium manufacturing. The properties in these cities are around 25% larger than their peers in Beijing and Shanghai. They require considerably more steel and concrete in construction. Without any demand or funding for developers there is likely to be little construction activity. People are likely to move away from these towns towards bigger cities where service sector growth will stimulate job creation.

Figure 2 shows a typical Tangshan property development halted in its tracks. This is representative of Tier 3 and 4 cities’ construction weakness, with10 cranes installed and no work happening.

Commodity prices in a downward spiral

The consequences for resource demand will be stark and we are presently seeing the impact of subsiding demand growth on commodity prices. Bulk commodity prices have fallen sharply (as shown in figure 3 below) as customer demand and financial solvency fell. The China Iron and Steel Association estimates that almost 100% of the Chinese steel industry is loss-making at a cash level (versus accounting). Companies need an injection of funds in order to buy inputs. Currently, this is being provided by traders on very short time horizons and murmurs have begun that mining company balance sheets are being used with delayed debtor payments. We will be keenly watching receivables balances of iron ore and coal mining companies during the February 2016 reporting season.

Speculation is growing that come Chinese New Year in February, many loss-making mills will not re-open after their traditional closure at this time of the year. Industry feedback suggests up to 80 million tonnes per annum (mtpa) of steel making could be lost in 2016, in addition to estimates of a 40 mtpa cut in 2015. This would result in over 10% of the Chinese steel industry closing – a mere step in the right direction of a long road to restructuring the Chinese economy. This would be positive for the global steel industry but it would be negative for coking coal and iron ore demand. Current utilisation levels in the high 60% range are unsustainable given steel mills need utilisation levels of over 85% to drive profitability and acceptable returns on capital.

The aluminium industry is marginally better. Cash losses are only confined to 80% of the industry but expected cuts to power tariffs will materially improve the economics of Chinese aluminium production to the detriment of non-Chinese supply. The forecast shortage of bauxite, the mineral form of aluminium, from the Indonesian export ban of unrefined commodities has not eventuated. Bauxite is abundant and Malaysia has filled the void left by Indonesia. Alumina is a commodity caught in the middle and as a consequence its price has collapsed. As long as China can source bauxite to produce alumina, Western producers will be cut out of the market. Western production of aluminium will continue to decline as China swamps the world with excess product at low prices. The demand panacea is not coming and supply will continue to grow in both aluminium and alumina. Rio Tinto’s approval of the South of Embley bauxite project in Weipa will further increase supply to China, further pressuring non-China alumina production.

Where once copper, zinc and nickel were thought to offer the biggest upside due to strong demand as China transitions from construction investment to consumer spending, the difficulties of a smooth transition are laid bare. Consumption of many of these products still remains in heavy industries. The roll-out of the electricity infrastructure was a large driver of copper demand. The current overcapacity in electricity supply has seen this dwindle, resulting in negative revisions to copper demand. Copper demand growth expectations have been reduced to a mere 1% while supply additions continue. Refiner margins for copper are growing as a result, with the impact being felt by the miners once more. Glencore’s decision to continue to operate its Mount Isa copper smelter is further evidence of improving smelter economics due to excess copper concentrate. Copper needs industrial production growth not just in China, but also in the rest of the world. Anaemic developed world growth suggests this is not coming. Doctor Copper is not giving a favourable judgement of global economic growth at present.

Conclusion

China is making the transition from infrastructure and construction-led growth towards consumer-driven growth. The consequence is lower demand for commodities, particularly the bulk commodities of iron ore and coal. Overcapacity issues are likely to be addressed in coming years but this is not a painless process. We expect the impact to be a continued decline in demand for commodities that supply these industries. While the demand outlook for copper and aluminium is favourable in the next five years, the impact of lower construction is likely to offset the demand from the consumer sector. The biggest risk to this view is that the Chinese government may announce a large stimulus spend like the 2008 RMB 4 trillion infrastructure spend, but this is likely to only be a short-term sugar hit, which is well noted by policy makers in Beijing. The more likely outlook is for slower growth and weakness in the commodity sector. Supply responses are necessary from miners to deal with the demand shortfalls. This has not been a very conducive environment for improving commodity prices in past cycles.

By James Eginton, Australian Equities Research Analyst, Nikko AM Australia

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This article was prepared and issued by Nikko AM Limited ABN 99 003 376 252 AFSL No: 237563 (Nikko AM Australia). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

The post China – Lost in transition? appeared first on AdviserVoice.

Background

Exports contribute around one quarter of Australia’s total economic output. Mining and energy exports accounted for over 50% of Australia’s total exports in 2014. Coal and iron ore were the top two largest exports by a comfortable margin, accounting for AUD 66 billion and AUD 38 billion respectively of the total AUD 327 billion of exports (ie a combined 32% of total exports).

In the energy space, natural gas (Australia’s fastest-growing export over the past five years) accounted for 5% of Australia’s exports, to be the third-largest individual export. Australia is now the third largest exporter of natural gas in the world and will be the largest exporter when the projects under construction are completed.

With commodities representing such a significant proportion of Australia’s GDP, shifts in supply and demand and the subsequent impact on our national income cannot be understated. This paper looks at the factors currently driving the demand and supply of Australia’s key commodity exports and the role other sectors may play in assisting Australia’s transition from relying on mining to non-mining investment for its growth.

Bulks and steel

The prices of bulk commodities, including iron ore, coal (both thermal and metallurgical) and steel continue to weaken due to a supply-demand imbalance. In particular, they are underperforming relative to already weak expectations. Rather than being a solely supply-related issue, as we have commented on in the past, it appears the slowing in growth in China and fixed asset investment (a key driver of demand for bulk commodities) has seen all bulk commodity prices fall to their lowest level since the global financial crisis in 2009.

The modest rally in the benchmark 62% iron ore fines price from USD 45 per tonne to above USD 60 per tonne appears to have been short-lived. The rally was a function of seasonally stronger steel demand, unusually wet weather in Western Australia and Brazil, and supply-side issues from Rio Tinto which has been impacted more than most iron ore miners as it ramps up its new infrastructure to 360 million tonnes per annum (mtpa). The result has seen China port inventories begin to normalise from highs, with a drawdown of stocks to mills of approximately 30 million tonnes (see figure 1). The surprisingly weak Australian supply looks to be the reason for the strength in prices from April 2015 to June 2015.

The currently depressed steel prices and new supply emerging in the iron ore seaborne market in the third quarter of 2015 are likely to weigh on iron ore prices for the rest of the year. Figure 2 highlights the deterioration in steel price spreads for the key construction steel, rebar. Steel prices have fallen to 2002 levels and utilisation levels at steel mills globally sit in the low 70% range, suggesting mill profitability in China, and the rest of the world, is very poor. This environment is not conducive to bulk commodity price rallies. As a result, coking coal prices have also been very weak in recent months, with a key Japanese quarterly coking coal contract for high-quality hard coking coal settled at USD 93 per tonne, down from USD 110 per tonne the previous quarter.

The medium-term outlook will be driven by a recovery in steel spreads and a return of mill profitability. In order to achieve this outcome, steel mill utilisation needs to recover to above 80%. There are two ways to achieve this. The first is to close capacity. Due to the impact on employment and the local government, it is unlikely the Chinese government will allow mills to close en masse, but this is the longer-term goal of the central government. Managing the transition away from being a manufacturing-based economy is a slow and difficult process so is not expected to occur in the next few years. The closure of steel mills will also be a key signal that the Chinese economy has transitioned to a less material-intensive services economy (although this signal is typically a later transition signal).

The other option is a demand-led recovery. This will require targeted stimulus to material-intensive industries. This may include stimulus for infrastructure or property construction. At this stage, it is not apparent that China will announce any stimulus measures. However, there has been recent speculation about the ’One Belt, One Road’ (OBOR) project (see figure 3), which is essentially the construction of infrastructure to support exports to regional neighbours.

OBOR includes the construction of ports, rail and road infrastructure in order to service China’s nearest neighbours in Europe and Asia as well as to the world. The difficulty with such a long-term strategy is how trading partners will respond to the flood of cheap Chinese bulk materials into their market and potentially causing harm to employment given they are significant employers. It will be interesting to see how the Western world responds. To date, trade cases to help prevent the dumping of material have been launched by the European Union and the United States in particular. Trade protection against China is likely to grow.

Base Metals

The aluminium complex, including its two key inputs alumina and bauxite, is facing numerous challenges. China has successfully found bauxite deposits outside of Indonesia, where a recent export ban was expected to drive up the price of the commodity. However, the Malaysian export of bauxite has been successfully substituted and hence provided less support for the underlying commodity price.

In addition, the recent change in the London Metals Exchange’s (LME) warehousing rule to reduce aluminium inventories has successfully released material which has put enormous pressure on the premium for physical delivery. At its peak in 2014, the premium sat at USD 0.24 per pound but has recently reached a low of USD 0.05 per pound. This premium was paid in addition to the LME index price. In addition to the changes in the warehousing rules, China, due to weak demand conditions and low aluminium smelter utilisation, has been increasing exports of the commodity, placing further pressure on prices. Exports were up 150% on a year-on-year basis to 420,000 metric tonnes in February 2015.

As a result, the alumina price has been under pressure more recently and the outlook appears very tough in the coming months, with weak aluminium earnings at the smelter flowing through to the midstream production of alumina, especially with the weak bauxite prices. The longer-term outlook also looks more challenging for ex-China alumina refining capacity as long as China can find a source of bauxite. Exporting of alumina to China is difficult as they prefer their own source of supply and the tough ex-China aluminium market, due to the significant oversupply of capacity, is likely to keep prices down, despite the more favourable demand outlook.

Copper, the general bellwether of economic growth globally, is also being buffeted due to a lack of demand and ample supply reaching the market. Longer term, the outlook for copper is robust with the growing rise of the Chinese consumer seeing an increasing demand profile, particularly for whitegoods and automobiles. At the same time, there are limited new copper mines coming on stream (and given the weakness in the global consumer versus the pre-GFC highs, copper scrap supply has also fallen) and an increasing decline in copper grades at mature mines. The next significant mine to be completed is MMG’s Las Bambas mine in Chile. While options exist for developing new mines, it has been clear there is great difficulty in developing large scale mines due to political and environmental issues. None more obvious than Rio Tinto’s experience in Mongolia with the Oyu Tolgoi underground development and more recently in the United States, and the push to develop the Resolution copper mine in Arizona. More positive news recently for copper has been the drawdown of copper inventories at the LME and the fall in treatment costs and refining costs at the copper smelters, which is a usual precursor to a tightening market for copper concentrates as it signals refiners need more copper concentrate.

Nickel, another Australian export, is also being impacted by weak Chinese demand. Similar to bauxite, the market had expected that the Indonesian export ban of unprocessed raw materials would lead to a jump in the nickel price. However, supply of nickel ore from the Philippines has been larger and better quality than expected. The question remains, how long can Philippine ore be a substitute for Indonesian ores, given grades are expected to decline? Offsetting this however, has been the substantial rise in LME inventories to the point where warehoused nickel equates to close to 12 months of demand (see figure 5). For the nickel price to rally, inventory levels need to decline. At this stage it is too early to say if the recent inventory decline is indicative of tightening market conditions or another false dawn.

Precious Metals

Gold prices have been remarkably stable over recent months, hovering at around USD 1,200 per ounce. The gold price is reflecting some level of uncertainty surrounding US interest rates and European instability relating to the possibility of Greece exiting the eurozone. Without a significant economic shock or poor economic performance in the US, it is hard to see much support in the gold price from here. The historical relationship has been an inverse one with the US dollar (USD). As the USD rallies, gold has typically sold off. With the lack of global inflation, and the likelihood of US rate rises driving the USD higher, the expectation, therefore is for the gold price to fall.

For Australian gold producers, there may be no significant change to the Australian dollar (AUD) realised gold price on the currency conversion. The AUD gold price has been around AUD 1,500, which for most Australian producers is generating significant cashflow.

Oil and Gas

The oil and gas market has seen significant volatility as the market attempts to digest the significant amount of new supply from the US onshore shale oil boom. At the same time as the US has successfully grown supply, Middle Eastern countries have added to an oversupplied market. As technology in shale oil drilling continues to evolve, it is likely supply will continue to grow from the US and thus put pressure on the price. The oil price is being driven by supply rather than demand, which remains robust. Due to the drop in price, there has been a re-emergence in demand for pick-up trucks and SUVs by US consumers, enhancing the demand side. Demand in the rest of the world is quite weak though.

Looking forward, and assuming no significant political instability in the Middle East (a brave assumption), the significant inventory build is likely to overhang the market, making any significant rebound in the price from USD 60 per barrel difficult to achieve. While rig counts in the US are down, which should reduce supply in time, the production curve for a shale oil well after it is drilled tends to see high production in the first 12 months before a significant decline in production occurs. As a result, these cuts are still four to five months away.

More concerning for the oil market, is the emergence of the carry trade, where traders buy the physical commodity and store it while buying the underlying commodity futures contract. As long as the cost of the futures contract and storage costs are less than the contango (which is the forward price minus spot price) the trade will be profitable. The implication is that there is a growing amount of oil inventory being held by traders which could potentially come out of storage and impact the spot price. This would only be a one-off shock but, given how a similar trade has unwound in the aluminium market and the consequence for realised prices, it could lead to lower oil prices. At this stage, this outcome is not a significant risk but is one that cannot be ignored.

The liquid natural gas market (LNG) is also experiencing oversupply. The Asian LNG price, which is determined by the oil price, has fallen in line with the oil price.  There is a significant increase in production from Australia and the US.  US production is priced off the Henry Hub gas price.  Historically, this has been at a significant discount to oil-linked pricing.  It was this discount that underpinned the rapid development of US LNG projects.  However, the oil-linked LNG price is now below the Henry Hub-based price which may slow the growth of LNG projects on the US Gulf coast.  Irrespective of this weakness, the LNG market is expected to be in oversupply until 2020 due to the number of projects currently under construction and due to start over the next five years.

Conclusion

A number of commodity markets, notably mining and energy are currently suffering from weaker-than-expected global demand, exacerbated by the slowdown in China. At the same time, due to the past high prices and the implementation of a number of new projects, the supply of many commodities has grown. Looking forward, the outlook for many of these commodity prices is heavily reliant on the strength of Chinese demand. Supply of most commodities continues to grow and will likely peak within the next two years. This may put further pressure on commodity prices.

The favoured commodities should be those linked to the growing consumer in China as well as those with declining supply, and copper appears to have the strongest fundamentals. Australia’s agricultural products, including our eighth largest exports, beef (which was Australia’s fastest growing export in 2014, rising 36%, reflecting higher prices and volumes) also stand to benefit from this theme as Chinese consumers increase their protein intake.

Our services exports, particularly education and tourism should also benefit. These sectors are Australia’s fourth and fifth largest exports respectively and are currently experiencing strong growth (rising 14% and 8% respectively in 2014) – benefiting from a weaker Australian dollar and the burgeoning Chinese tourist market and their increasing desire to be better educated. Australia’s total exports of services, led by tourism and education, slightly outpaced iron ore exports in 2014. Services were traditionally more than double the value of iron ore exports prior to the explosive growth in China’s steel industry in 2004. We are thus starting to see a return to normal and we will likely see services rise in importance in Australia’s exports in the years to come.

By James Eginton, Research Analyst, Nikko AM Australia

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This material was prepared and issued by Nikko AM Limited ABN 99 003 376 252 AFSL No: 237563 (Nikko AM Australia). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

The post Commodities – supply has arrived but where is the demand? appeared first on AdviserVoice.

James Eginton

2014 marked a significant transition point in the iron ore market, with supply greatly overtaking demand. Indeed, combined production increases from the major iron ore producers including BHP, Rio Tinto, Fortescue Metals and Vale, likely exceeded 120 mtpa (million tonnes per annum) last year.

Meanwhile, 2014 witnessed a slowdown in Chinese economic growth, and in particular its domestic consumption of steel, but steel production increased on the back of a surge in exports to approximately 90 metric tonnes (approximately 10% of Chinese production). Excluding exports, demand for steel within China grew at less than 1%, hinting that fixed asset investment growth has likely peaked. All eyes now turn to whether the Chinese consumer can step up and provide the next leg of growth for the emerging economy.

2015 will mark another year of substantial supply-side growth for the seaborne iron ore market. Rio Tinto and BHP both remain 60mtpa away from their stated goal of production at 360mtpa and 290mtpa, respectively, with clear potential to expand beyond this. Roy Hill, the Hancock Prospecting mine in Australia, begins commercial production in the September 2015 quarter while Fortescue desires approximately 10-15mtpa of supply growth. The supply surge is not restricted to Australia but includes production from Brazil, with Vale looking to add another 150mtpa in the next three to four years. For BHP, Rio Tinto and Vale, these additional tonnes will be low cost and with a high profit margin, with cash costs for BHP and Rio Tinto likely to fall below US$35/tonne Free On Board (FOB) by the end of 2015. At current iron ore prices this would see cash margins of well over US$30/tonne.

Interestingly, input cost relief is likely to provide short-term help to junior miners. Declining diesel fuel costs, falling currencies of commodity exporters and freight rates halving will have the effect of giving hope to these miners, which will likely compound the oversupply issue. For example, several of the largest junior miners, with a combined production of 30mtpa, will continue to supply the market, even as they continue to burn through cash, in the hope of a rebound in the iron ore price. Inevitably, however, these lower costs for production for marginal producers will likely just reduce the cost curve support price, leading to even lower prices and greater consumption of cash reserves. In our view, it is likely that one relatively large producer in Australia will encounter pressure repaying debt, as its debts now precariously exceed its equity market value.

On the positive front for iron ore prices, a supply response has been seen from non-traditional producers outside of Australia and Brazil. In particular, Chinese domestic production that does not have a freight advantage (i.e. proximity to steel mills) and other regions including Africa, Iran and Indonesia cut production of approximately 150mtpa in 2014, with further closures likely in 2015 and beyond.

Importantly for the iron ore price outlook for 2015, the March quarter will be the strongest for pricing due to weather disruptions with a couple of tropical lows having been encountered by Port Hedland in Western Australia in January so far, one of which required the closure of the port for less than 24 hours. Interestingly (and tellingly), these have not yet resulted in any material rally in the iron ore price, a sign perhaps of weakness in Chinese steel demand. However, after the end of the March quarter and as new low-cost supply is added to the seaborne market, iron ore prices will likely fade at least until the end of the September quarter. Thus, an iron ore price in the low US$50s per tonne could be a distinct possibility by that time, which is more than a 20% decline from current prices.

From a steel perspective, 2014 saw a recovery in steel maker spreads (the cost of steel less the input costs to make steel) from their 2013 lows. However, this was due to the decline in input costs outpacing the fall in steel prices. Anaemic steel consumption within China will likely continue and growing protectionism around the world will likely cap the ability of Chinese steel industry to continue to export its way out of trouble. Without further stimulus targeted at infrastructure and property development, it is difficult to see the Chinese steel sector outperforming and steel spreads could potentially collapse back towards their 2013 lows (see chart below).

The recent Chinese reduction in export rebates for Boron steel has reduced support for Chinese steel within Asia even further, offering limited hope of meaningful steel spread increases in US dollar terms. Indeed, if there is any hope for regional steel producers’ spreads, it is likely to come from currency depreciation relative to the US dollar.

Conclusion

The steel industry and its underlying iron ore industry are witnessing excess production and deflationary forces that are similar to the global energy markets. Industrial rationalisations are likely in the coming quarters, involving important credit events in several countries, but the situation should weaken before it improves, in our view. The upside risk is that China, fearing the political effects of economic and financial retrenchment more than its zeal for reform, aggressively increases fiscal stimulus and thus perhaps fixed asset investment. Without this, the situation will likely remain quite challenging for the steel and iron ore markets even beyond this year.

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By James Eginton, Research Analyst, Nikko AM

This material was prepared and issued by Nikko AM Limited ABN 99 003 376 252 AFSL No: 237563 (Nikko AM Australia). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

The post Steel and Iron Ore Deflation to Continue appeared first on AdviserVoice.

Significant investment has been made in infrastructure and housing, which has driven the considerable growth in demand for steel and, as a result, for iron ore. James Eginton, Research Analyst at Tyndall AM, provides an outlook for both of these markets and explains why 2014 is set to be a year of transition as these supply and demand dynamics change.

The iron ore market

Whilst steelmaking capacity in China has kept pace with the surge in demand, it has been the supply of iron ore that has lagged and has, as a result, led to a quadrupling of the iron price over the past 10 years.

Key to the supply issue of iron ore has been the inability of the Brazilian producers to add incremental new supply to offset mine maturity, as well as the environmental and political challenges that have faced the world’s largest iron ore miner, Vale. Chart 1 highlights the inability of Vale to deliver net new tonnes.

The seaborne response to the Chinese demand for new iron ore has been led by Australia. It has been dominated by production increases from the incumbent majors, BHP Billiton and Rio Tinto, but has also been supported by the successful growth of Fortescue Metals which is now the fourth-largest iron ore producer globally. Chart 2 highlights the seaborne response from Australia versus Brazil, which has continued to find it difficult to add additional net tonnage to meet the ever-increasing demand from China.

The importance of the supply response is the main driver in reducing the key input cost into steel making – iron ore. The slow response of the supply of iron ore versus the more timely increase in steelmaking capacity has caused sharp spikes in the iron ore price and has led to low profitability of steel mills.

Supplementing iron ore over the past five years has been the high cost, low-quality domestic iron ore from within China. Ore grades in China are as low as 15% (versus the global benchmark of 62%) and require significant beneficiation (refinement) in order to be useful in the steel making process. As a result, a large proportion of Chinese iron ore sits high on the iron ore cost curve. Chart 3 highlights where the Chinese ore currently is assumed to sit at around USD 130 per tonne CIF (costs of production, insurance and freight).

In order for the iron ore price to fall, this low-quality tonnage needs to be removed from the market and replaced by lower-cost Australian and Brazilian iron ore.

2014 marks an important year in the supply-demand balance for iron ore, as it’s likely to be the first year since 2004 that the iron ore market will move towards a small surplus. The size of the surplus or deficit depends on assumptions surrounding Chinese steel consumption, but it is clear that 2014 will see significant additional iron ore produced at a lower cost than Chinese domestic ore. Iron ore supply additions will total close to 200 million tonnes with Rio Tinto, BHP Billiton, Fortescue and Vale contributing approximately 120 million tonnes of this new supply.

The expectation is that the iron ore price will fall from its current price level of around USD 130 per tonne towards USD 110-120 per tonne, with significant declines likely after the second quarter of 2014 and following the cyclone season in Western Australia and Brazil, which has the potential to cause significant disruption to seaborne supply.

Currently, 270 million tonnes per year (on a 62% iron content equivalent) is sourced from Chinese domestic suppliers. Morgan Stanley forecasts that within four years, 70 million tonnes per year will be removed and supplemented by seaborne supply (source: Global Metals Playbook: 1Q14, research paper, 22 January 2014). This is despite Chinese steel consumption growing by 2-2.5% per year in the same period (which should necessitate more iron ore consumption). Thus, the seaborne market, in particular Australia, will be important in displacing this domestic Chinese tonnage.

Looking to the medium term, the iron ore price is also likely to exhibit significantly lower price volatility than it has displayed in recent years. Chart 4 highlights the reason for the lower volatility and it surrounds the flattening of the iron ore cost curve.

Chart 4 highlights that in order to displace 200 million tonnes of iron ore demand in 2013, the iron ore price will need to fall by USD 70 per tonne due to the steepness of the cost curve. However, looking to 2018 and assuming forecasted supply comes to the market, the same 200 million tonne move in supply will only result in a USD 20 per tonne movement in the iron ore price. This will make the iron ore market far more stable in terms of pricing and should assist steel maker margins in the long run.

Nearer term, however, the steepness in the cost curve has the potential to create a volatile iron ore market. The current cyclone season in Western Australia and wet season in Brazil has already seen Port Headland and Cape Lambert closed for two days and Vale declare force majeure due to heavy rains in the south east of Brazil which lasted for approximately a week after Christmas.

The impact was seen in the iron ore prices which ran up to USD 139 per tonne and subsequently moderated back below USD 130 per tonne in mid-January on the resumption of normal supply. The cyclone season in Western Australia and wet season in Brazil will normally run through the first quarter and into the early part of the second quarter.

After this period, new iron ore supply and the potential for Indian iron ore stockpiles in Goa to hit the market threaten to force prices lower through the second and third quarters. The impact will depend on the strength of Chinese steel consumption and inventory levels.

Restocking of iron ore inventory by Chinese steel mills is unlikely to provide a catalyst to promote further buying in the spot market as levels appear to have returned to normal for this time of year, steel mill profitability is low and credit remains tight for steel mills and steel traders. Chart 5 highlights that despite restocking taking place over the second half of 2013, iron ore prices have been relatively stable. This also adds support to the view that the iron ore supply is finally catching up to Chinese demand.

India remains a potential catalyst for pricing volatility in iron ore in the immediate term. Whilst we do not expect the key exporting region of Goa to begin mining within the next 12 months, the issue is what happens to the 11.5 million tonnes of iron ore inventory that is sitting at the port, which the courts have recently approved for sale but had been previously been banned by the government. If this floods the seaborne market in the second and third quarters, it will materially affect the price of iron ore and is a key downside risk.

At this stage, it is expected that the majority of the tonnage will remain within India and be sold to Indian mills as they face concerns about iron ore supply going forward, particularly from the key producing region of Odisha. India has the potential to be a net importer of iron ore and steel in the next two years.

The steel market

The steel side of the story is a case of historically high input costs coupled with overcapacity, leading to margin compression and an industry that is seeing record steel production and consumption, but has been unprofitable for a number of years. China has been the key to global consumption growth but has also been the cause of significant capacity additions.

Market expectations on steel consumption growth for 2014 are around 3-4% in 2014, with Chinese steel consumption totalling approximately 800 million tonnes. By 2017, market expectations are for close to 1 billion tonnes of steel being consumed in China alone. To put this into context, 2013 world steel consumption was 1.6 billion (including 775 million tonnes from China).

Steel consumption is likely to shift during 2014 (and into the medium term) from infrastructure investment towards consumer products as Chinese consumers increase their spending on air conditioners, fridges and dishwashers. Infrastructure spending growth is beginning to moderate with significant investment in rail, roads and electricity having previously been made. This may also mean the shift in steel consumption from long products such as rebar used to support the steel structure in buildings and infrastructure projects to flat products including hot rolled coil used in products such as refrigerators. These two products are produced at different mills and at different quality specifications (with flat products being the higher specified product).

Despite the significant growth in steel consumption, profitability in the sector has been very weak. The key for steel spreads and steel mill profitability to improve in the near term appears to be input cost relief rather than steel price improvement. This is due to the low steel mill utilisation levels which are currently hovering just below 80%. It is assumed that mills need to operate utilisation rates above 85% in order to get pricing power. This is unlikely over the next 12 months. Chart 6 highlights how capacity additions have exceeded production over the past five years leading to weak utilisation levels.

As mentioned previously, there is some hope that iron ore prices will moderate over the next 12 months on the significant new, low-cost supply that is entering the seaborne market. This may lead to margin improvement for steel. Margin improvement is unlikely to be driven by significant price improvement for steel. In the near term, steel prices are unlikely to see significant upside as mill inventories have been high for this time of year, leading to lower levels of restocking and credit conditions in China for mills and traders remaining tight (see Chart 7). Growth in steel consumption above market expectations would be required for material steel price moves.

Looking to the medium term, one potential catalyst for a recovery in utilisation levels (and a subsequent recovery in steel-making margins) is Chinese environmental reforms which could have the effect of curbing capacity.

China has recently announced the closure of obsolete capacity with the plan to phase out 60 million tonnes per year of capacity in the Hebei region alone. A large reason for this push is due to the poor air quality in Beijing which has forced the government to act on air quality, particularly around heavily populated regions. The closure of the obsolete capacity could be the key difference. Past pushes by the government on environmental reforms have not been successful in improving air quality nor has it reduced new capacity.

The key issue in reducing capacity and pushing for environmental reform is that it runs counter to local government objectives on employment, with the steel industry being a large employer in many regions. For example, in the key steelmaking region of Hebei, 15% of workers are in the steel industry and it represents close to 30% of the region’s business income (which is taxable). This makes it a challenge and often puts the local government at odds with the central government. How the central government in Beijing is able to deal with this issue will have a significant bearing on whether net capacity closures are made or whether capacity closures in the region are merely replaced by new mills. It is too early to say which is likely to happen, but has the ability to be a significant upside to steel margins in coming years.

Conclusion

Overall, 2014 marks a transitional year for the steel and iron ore industry. It marks the first time since 2004 (excluding the global financial crisis) that the iron ore market will transition from being in a deficit position (where demand has exceeded iron ore supply) to a mild surplus. This is due to new supply, largely from Australia. At the same time, the Chinese central government has been pushing environmental reforms which could have the effect of improving steel mill utilisation through capacity closures. This is at a time when steel consumption continues to grow (albeit at a slower rate than recent history). As a result, the outlook for steel makers has begun to brighten with the potential for margin expansion and improved financial performance. India continues to remain unclear as to their position in the seaborne market for both iron ore supply and steel consumption. Political uncertainty makes it look increasingly unlikely that India will re-enter the export market with the supply of iron ore, whilst on the steel consumption side, growth in consumption is expected to be supported by internally produced steel. China too remains uncertain as to growth and the desire of the government to push environmental reform.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. TIML is part of the Nikko AM Group.

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