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Iron ore heads down again -- Lower for longer?

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Major iron ore miners are increasing output in fierce market-share competition. (Christmas Creek iron ore mine in Western Australia, November 17, 2015)   © Reuters

SINGAPORE -- The world's biggest iron ore miners believe that the recent rally in the price of the commodity will not last, because, while demand remains mostly flat, they have committed to maintaining or increasing their supply.

The price of iron ore, a key raw material to make steel, has fluctuated wildly so far this year, with the Northern China benchmark price plunging to a 10-year low of $39.30 per metric ton in January, a fraction of the commodity's record high of $188 a ton in February 2011.

But in the past two months a rally has caught markets and forecasters by surprise as the price almost doubled to $68.70 on April 21, before beginning a steady slide to close at $50 per metric ton on May 25, according to Platt's The Steel Index.

At the annual Singapore Iron Ore Week forum, held between May 17-20, the questions on everyone's lips were what has driven a rally that few saw coming, and what comes next?

Seasonality has certainly played a part. The year's second quarter is traditionally the best for the commodity due to factors including cyclones in north-west Australia, the world's largest production area for seaborne iron ore, and restocking in China, which consumes about 50% of the commodity as its peak construction season ramps up.

Vicky Binns, iron ore marketing vice-president at BHP Billiton, the world's largest mining conglomerate by revenues and market capitalization and No.3 iron ore miner, said that the basic fundamentals of supply and demand had not underpinned the recent price surge.

"We see it as a temporary rally but one with unconvincing fundamentals," she said.

While explaining that the company had been surprised by the strength of the rebound in China's topline housing statistics, she noted that it had been driven by a sharp expansion of credit by Beijing. This has seen billions of yuan lent by state-run banks pour into the nation's infrastructure and property markets, triggering higher steel prices and stronger demand for its main ingredient, iron ore.

"More than 50 million metric tons of additional steel capacity has been started in China during the first quarter, that's up another 8% year-on-year," Binns said, adding that trading at the moment was, in the company's view, based on sentiment rather than on supply, which is continuing to rise as new mining projects come online, and demand, which has risen but has been held back by the price hike between January and April.

Monetary easing

But it is the "old economy" strategy of government stimulus that has largely been behind the improvement in the steel heavy infrastructure and housing construction markets in China that consume more than 50% of steel produced by the country's mills, Tim Murray, managing partner of China-focused J Capital Research, told the Nikkei Asian Review.

It is a strategy that Chinese policymakers keep reverting to in order to prop up the country's top-line growth. They are frustrated that the long-promised "rebalancing" from the old economic model, which is reliant on construction and heavy industry, is not yet being replaced by a newer, more sustainable model based on domestic consumption and services.

In such an environment, Binns warned that the amount of future Chinese stimulus is somewhat in question, a comment underscored by a rare public debate sparked by a recent article on the front page of the Chinese Communist Party's main media mouthpiece, The People's Daily. The piece in question queried the wisdom of further momentary easing, which will simply spark a fresh surge in activity in the already over-supplied construction sector, as well as raising demand for steel.

The problem outlined by critics is that with each monetary easing, China's state-owned corporate and local government debt is becoming a more serious concern of global economists and international markets, and of the more conservative Chinese policymakers. The issue spirals upwards as money is lent by banks to developers to build more ghost cities and "bridges to nowhere", as some of China's locally-funded, white elephant infrastructure projects are known.

In a sign that the money printers have been ordered to slow down once more, Binns noted that early figures showed steel production in April was already softening.

"That the so-called debate is being played out in public shows that government policy is confused and uncertain," said Murray.

The uncertainty extends to industry watchers. The unexpected rise in iron ore prices has forced research analysts to lift their forecasts for 2016 average prices. Ahead of the rally, a number had predicted prices averaging as low as $35 per metric ton -- and the market consensus now stands at about $46 per metric ton for this year.

Still, as the average for the year-to-date is just over $51 per metric ton, according to TSI, this means miners will take the pain in the second half of the year.

"We'll have to prepare for tougher periods," warned Claudio Alves, global director of iron ore marketing and sales at Brazil's Vale, the world No.2 iron ore miner. "The price less than one month ago was more than $70. When you come back three months ago, it was $38. This shows there's a big volatility."

Binns said that while BHP is positive in the longer term about Chinese demand, the company had cut back its forecasts of peak Chinese steel production from a long-standing estimate of 1.1 billion metric tons per year, to around 950 million tons, a step down that will see Chinese annual requirements of iron ore lowered by about 100 million metric tons.

Murray, along with the China Iron and Steel Association, questions even these forecasts.

CISA's view is that so-called peak steel was about 820 metric tons in 2014.

And Murray predicts that Chinese steel production will fall 4% this year and does not agree with the long-term prediction of miners like BHP.

Meanwhile, the Chinese authorities have cracked down on the speculation that observers believe was partly responsible for the recent price surge.

Pressing ahead

Yet despite volatile and sometimes low prices, major miners remain committed to their expansion projects, Alves confirmed that Vale's new S11D iron ore project in Brazil, which is aiming to produce an extra 90 million metric tons of high-quality iron ore, would be completed at the end of 2016. BHP and Rio Tinto, the world's second-biggest miner, also confirmed projections of an uplift in production in 2017, although they have both lowered their guidance.

"Both BHP and Rio have downgraded guidance for 2017, and we expect that Vale is likely to disappoint in its delivery of S11D as well as its ongoing struggles with the Southern System mines," noted analysts at investment bank Macquarie in a recent report, referring to a network of mines in Brazil.

Australian miner Hancock Prospecting's Hope Downs mine, which shipped its first cargo of iron ore last year, has been slower than expected to ramp up production, and is only producing about 10% of its planned 55 million metric tons output.

In any case, none of the mining majors would sit back and see a rival invest in a large production increase without following suit, with all of them determined to hold on to their market share.

Now, following two years of impressive cost reduction programs, the big miners are in a better position to manage much lower prices as they prepare to ride out a cyclical dip that many believe will see "lower for longer" ore prices.

Some good news exists in that cheaper, better-quality ore from Australia and Brazil has forced the shutdown of some of China's lower-grade domestic output. But this threat to seaborne exporters has been replaced by China's growing production of scrap metal, a partial substitute for iron ore in the steelmaking process.

China's decades of modernization have resulted in a stack of obsolete machinery, and the process of replacing metal-rich structures including housing, offices and warehouses continues, BHP's Binns noted, adding that this would further cut into demand for iron ore.

The final piece of the equation that is now driving the price back down are the huge stocks waiting in ports, which recently topped 100 million metric tons.

"With plentiful supply and traders loaded up with product, steel mills no longer need to hold such high inventories," Murray said, adding that this helps to improve cash flows for steel makers, if not overall profitability.

Murray also poured cool water on what he believes is premature excitement about an increasing number of construction starts, a closely-followed market that points to future demand for steel and iron ore.

Following a recent visit to 10 Chinese provinces, he noted that most sites listed as "starts" had cleared land, but were making no preparations to erect buildings.

"We are not even back to 2014 levels," he said, adding that fundamentally his group believed "nothing has changed and all I can see is the market going backwards."

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