Global Iron Ore Glut Looms…

I’ve been a skeptic of the sharp rally in iron ore prices since Q4, which runs contrary to the weakness seen across industrial metals on growing global inventories and relatively weak Chinese demand, and has begun reversing. The Australia Bureau of Research and Energy Economics in its latest analysis forecasts the key 62% iron content contract price averaging US119/mt this year from a current price of US$136, but falling below $90 by 2018. In 2013, Australian iron ore exports are forecast to increase by 12% y/y, to 554mt on higher production at a number of existing and new mines. Global seaborne supply will head into surplus this year, outpacing demand by 20-25m mt, from a near 40m mt deficit last year. Heavy Australian investment in new capacity is expected to drive export growth of 8% a year from 2014 to 2018, to reach 831m mt. Where is the additional supply, equivalent to half last year’s output, going to go?

Back in the 29th June 2011 note on the Chinese steel industry, I noted that: ‘For investors in Australian resource companies, it’s worth noting that Chinese iron ore capacity is still expanding and won’t peak before 2015 at between 1.5bn and 1.6bn mt, up from less than 1.1bn mt last year and an anticipated 1.3bn mt in 2012. Even allowing for the inferior quality of local ore, as China increases its iron ore production capacity and smaller mills curtail production, iron ore imports should begin to fall as soon as early 2012, undermining global prices.’ That was pretty much the beginning of a sharp de-rating for global resource stocks sustained into Q4 last year, and that slump in iron ore prices indeed happened, before an unsustainable bounce in recent months on the China fixed investment surge and opportunistic restocking.

Crude steel output rose 9.8% last month to 2.21m mt on a daily average basis, breaking the previous record of 2.05m, set in January and versus only 1.86 million tons in December. That reflects investment in fixed assets rising 21.2% y/y in the January-February period and the auto market starting the year with a 15% sales gain. Cement and copper production have also been rising in anticipation of a renewed construction boom. However, China’s steel industry has about 35% excess capacity totaling 970m mt in 2012, while output was only 717m mt and consumption at around 700m. The government has been trying to cull capacity and consolidate the industry; Hebei, which is China’s largest steelmaking province and  accounts for more than 25% of national output, is pushing to cut its output by 60m mt this year, but implementation remains a challenge and curtailing steel overproduction will be a key test of the rebalancing/reform agenda. The Chinese government is seeking to encourage mergers and close obsolete smelters, with the aim of bringing 60% of total capacity under the control of the top 10 mills by 2015. 

Exports of Chinese steel products last month rose 25% y/y to 4.24m mt, and exports have exceeded 4m mt every month for the past year, depressing global steel product prices and profitability. Despite modestly rising prices since Q4, many domestic producers of long semi-finished steel stock reported losses of up to 300 RMB/tonne last month as prices for iron ore surged. The economics of Chinese steelmaking are clearly unsustainable without massive capacity write-offs and lower input costs. Meantime, major Australian miners are committed to significant capacity expansion over the next three years. Despite recent pro-shareholder value management changes after a spate of value destructive acquisitions and weak share price performance versus the wider equity markets and commodity prices, it would be very hard to reverse these plans. Somewhere in the region of 90m mt of additional iron ore supply will hit the market by end 2013. There is also the possibility of India lifting a ban on iron ore mining in Goa during 2012, accounting for 40-45Mtpa of exports, which would add to potential oversupply.

China’s total iron ore imports hit a record of 743.6m mt in 2012, up 8.4% y/y, even though steel output was only up 3%, versus almost 9% in 2011. The jump in Chinese demand in Q4 was partly opportunistic buying after the sharp price declines, and partly driven by a pickup in construction related output as infrastructure related FAI surged.  GDP in China at 7.5-8% should translate to a 3-4% steel output growth per annum given the historical FAI relationship, but it’s likely that the investment and thus resource intensity of that growth is now peaking. Meantime, probably about half of China’s steel industry is unprofitable at current ore prices and domestic producers continue to complain about a pricing cartel in iron ore, driving China’s efforts to directly secure its own overseas supplies.

Iron ore is essentially in a transition to structural oversupply and below-trend prices by mid-decade. Aside from the surge in Australian output, key drivers of this more subdued demand outlook are the growing role of scrap in Chinese steel production, and ongoing investment in Chinese domestic iron ore production. After its decade long production boom, China will be generating growing volumes of steel scrap through this decade, in line with historical trends in more mature economies. Secondary steel production look set to account for about 20% of total production in China by 2020, up from 12% in 2012. This implies a reduction in iron ore consumption of 140mt, all else being equal.

An iron ore price recovery from a brief slump that pushed the spot iron ore price down to US$86.70 last September peaked at US$158.90/mt on February 20th; since then it has fallen to $136. The key question is whether high-cost Chinese iron ore production will be shut as iron ore production expands in Australia and elsewhere and if so at what price for iron ore. It seems unlikely that an iron ore price much above $85-90 can be sustained medium term, unless China slashes domestic mining output. Total sea-borne iron ore exports will surge from 1.15bn mt this year to 1.5bn mt by 2015. Chinese iron ore production is still expected by most independent analysts to increase by 3-5% a year over the same period, even though it is much higher cost. This is contrary to the previous consensus view that lower-cost foreign production will replace higher-cost Chinese production as it comes on stream. Miners have argued that prices will be underpinned as marginal Chinese iron ore producers shut down, but excess capacity across all sectors in China rarely obeys strict economic logic, given the role of provincial governments in supporting ‘strategic’ high-employment industries.

If they don’t shut, the likely global surpluses looks set to exceed 200m mt by 2015 and approaching 350m by 2017. A reasonable longer-term (2015-20) price projection is US$90 a tonne landed in China; given that iron ore costs about US$20 a tonne to ship to the Chinese steel mills, the only local iron ore miners that will be clearly profitable at that price are Rio, which have cash production costs of US$25-30/mt, versus Fortescue at over US$50/mt, although additional scale for the latter will bring its average cost of production closer to Rio’s.  Therein lies the industry dilemma; it makes perfect sense for the likes of Fortescue to ramp up production to reduce  marginal production costs toward industry average, even as it helps crash overall prices. The iron ore price is unlikely to sustain a move above US$100 until about 200m tonnes of high marginal cost production are forced out by cutbacks and closures though late decade, either in China or overseas, bringing the market closer to balance given global demand growth. For the leading Chinese steelmakers, a culling of domestic smelting capacity but not of iron ore output would be a very positive structural margin story.