|Summary: The iron ore price is defying gravity, but it’s about to head back to Earth. Ore production is increasing, while seasonal demand from the likes of China is tapering off. The spot price is likely to fall ahead of a pick-up ahead of the Chinese New year.|
|Key take-out: Ore prices are expected to come under pressure by the middle of 2014, and high-cost Australian producers may struggle to remain profitable.|
|Key beneficiaries: General investors. Category: Commodities.|
Iron ore is a closely monitored commodity. As Australia’s largest export, ramifications of price volatility are felt beyond those fortunate enough to produce it.
Consuming roughly two-thirds of the seaborne trade in iron ore, the price is a bellwether for the state of the construction cycle in China. With the Central Government clearly articulating the need to rebalance its economy, the longer-term outlook for steel production, and hence the iron ore price, is negative.
This played out in September last year when the price dropped to below $US90/tonne, a level not seen since the GFC. However the rapid and sustained recovery to $US140/tonne has challenged this conventional view.
There exists a distinct seasonal pattern for steel production in China. Poor weather conditions impact construction activity each year, constraining demand for steel at this time. As shown below, this seasonal weakness can largely impact the price of iron ore. Thus far in 2013, we are yet to see any reduction in output from Chinese steel mills and this has supported the iron ore price.
Fig 1 Seasonality in Iron Ore Market (top) and China’s crude steel production rate (bottom).
Infrastructure and residential construction account for nearly 40% of Chinese steel demand. The strength of these sectors are dictated by government sponsored projects and the confidence of property developers. A number of large infrastructure projects that were on hold last year ahead of the transition to the new leadership are now progressing. Credit availability has also improved post the SHIBOR rate shock (the decision by the Chinese central bank in June not to prevent a rise in the Shanghai interbank offered rate) and with property prices moving higher, developers are ramping up residential construction again.
Fig 2 highlights the recovery taking place in these two sectors, supporting steel mills current enthusiasm.
While those infrastructure projects that were on hold last year are now being finished, I am not expecting any major new stimulus programs to follow. Similarly with residential construction, while there is a short-term uplift, the recovery may be short-lived because the government is keeping a close eye on credit growth in the shadow banking system.
With softer domestic steel demand earlier in the year, Chinese mills have been exporting an unprecedented 5 million tonnes a month into Pacific Basin markets. This had sparked a wave of anti-dumping claims, including from Australia’s Bluescope Steel. Steel production from mills in Japan and Korea has fallen 5% year-to-date, leaving these mills with surplus capacity. This will cap steel prices, which have been stronger in recent months. Not forsaking a firming in domestic demand, Chinese mills are barely profitable and are resisting any further iron ore price increases.
As we enter the second-half of 2013, a significant amount of new iron ore is hitting the market. Rio Tinto, Fortescue and Vale will increase production by an annualised 150 million tonnes. This increase in supply will coincide with a seasonal weak period as described above.This will likely push the iron ore price down in the short term to a range of $US110-120.
All Australian miners will remain very profitable at these levels, especially should the Australian dollar continue to fall. As usual, demand will pick up at the beginning of 2014 into Chinese New Year, which could easily see the iron ore price rally again. However, this is likely to be the last such instance.
Further significant iron ore additions will occur in 2014 as a result of over US$150 billion of project investments. This will likely occur at a time when steel production slows.
New Premier Xi Jinping is acutely aware of the challenges facing the economy and is unlikely to further accelerate growth through investment stimuli. The Chinese steel industry faces significant economic strain, weighed down by over 200 million tonnes of excess capacity. There exists a risk that the strength we have seen this year has pulled forward demand, creating a vacuum for mills in 2014. Steel production in China will continue to slow and likely peak near the end of the decade. The market for iron ore will begin to shrink before this time as scrap generation ramps up.
Iron ore companies are highly leveraged to the commodity price. Recent strength in prices has seen strong rallies for the sector. I expect the iron ore price will pull back shortly, followed by a rally into Chinese New Year, and it is likely that share prices will follow. By the middle of 2014 prices will come under great pressure and I believe a number of high-cost Australian producers may struggle to remain profitable.
Justin Braitling is a principal of Watermark Funds Management at www.wfunds.com.au.