April 21, 2017
FIS Q1 Review: Is the iron ore market in a new pork cycle?
During the first quarter of 2017, the trend of iron ore market appeared to resemble a pork cycle; where encouraged by high prices, suppliers produce more to capitalize on the high prices, only to see prices fall due to oversupply. Then, the lower prices forced some suppliers to leave the market, which inevitably leads to higher prices as supply diminishes.
Of course, this is a simplification of a complex, ever-changing market influenced by macroeconomic and microeconomic factors during the quarter. Thus, the key of breaking this cycle may lie in improving demand and China seems to offer some solid solutions with a new infrastructure stimulus program to kick-start their economy for rest of the year.
In the meantime, the Chinese authorities worked hard to limit credit availability from their previous stimulus package introduced in early 2016. At the same time, the Chinese government is also trying its best to cooldown the heated property market spurned off by the stimulus package of 2016. Thus, along the journey of this “new pork cycle”, iron ore and steel prices have intertwined with this trend.
Housing vs road, railway and waterways construction. Fundamentally, this is the basic difference between the 2016 stimulus program to 2017 stimulus package, whereas the infrastructure spending of 2017 focused more on public works – the construction of railways, highways, waterways transportation –as compared to the 2016 package which was primarily focused on housing sector.
China has since become very efficient in building housing projects and the some complexes can be rushed within 3-6 months periods using up huge chunks of steels materials. This consumption can be readily being felt by the market. By contrast, the 2017 rails and waterway infrastructure projects run on a longer-term basis and take longer periods before their impact is felt by the market.
Spillover effects on early months of Q1
As such, the spillover effect of 2016 housing stimulus had been felt in January- February 2017, where Tangshan steel billets prices often used as barometer of steel demand were still high, creating a huge RMB 400-500 margins for the mills in steel-making.
Then, the pork cycle crept in, as mills ran almost on full capacity in producing much steel products, and kept producing as long as the margins can hold. Iron ore prices also hiked in tandem to the steel demand with saw Tangshan steel billets prices peaked at late February to RMB 3,300. Likewise, iron ore prices also reached an apex at late February at the range of USD93-95/mt. It was also during this period that TSI Iron Ore 62% achieved its zenith during February.
Fig 1: SGX Iron Ore Volume vs TSI 62%
Long run to ruin or a temporary speedbump. With iron ore and steel prices enjoying their finest moment in late- February, things started to descend as an overwhelming supply of materials finally made their mark in denting the prices.
In iron ore market, spot prices plunged toward USD63-65/mt in mid-April, almost a 30% drop as compared to the zenith in late February. Similar story was seen in Tangshan billet prices with correction toward RMB 2,700 in late April as compared to peak of RMB 3,300 recorded in late February.
This downward trend has gotten the attention of the market as April is traditionally the start of spring construction activities in China, where demand of steel and iron ore were expected to be high or the highest during the year. However, the buzz of spring construction activities failed to impress market critic and we will explore the reason in the followings:
1) Tightened Monetary Policy:
China, as well as other western countries have entered an “interest rate hike” cycle, or simply trying to tighten the supply of money. In this scenario, the commercial bank will raise the requirement on obtaining for business loans. Then, this will limit the cash-flow of trading companies and mills that depended on bank loans to repay the purchase on materials. In turn, the mills and trading companies will focus more on repaying loans toward the end of quarter, draining them of less cash-flow for speculation on materials procurement.
2) Falsification on M1 and M2:
As we know, M1 represents money available to make investment, or “check account”, while M2 means “saving account” in China. Some investors believed that the current M1 has exceeded M2 at historically high by 15% as compared to last year. Thus, they interpreted the trend as a good time to push for property investment in China. However, this is simply an accounting trick. M1 is cash account of land developers, which are deposited by individual house buyers and
the shifting of M2 to M1 normally occurred when participant makes some house purchases. Investors figured out this trend just after the authorities in Beijing put up a series of restriction on house buying as of early March 2017.
3) Mills Talk:
For China-based mills, as long as there are margins to be made, they will produce. In the earlier months of 2017, mills were heard to enjoy RMB 500 margins from steel-making. However, the margins have since narrowed to RMB 100-200 due to rising coking coal prices and lower steel prices. Despite the Chinese government’s strong urge on capacity cut, the mills still produce roughly 96 million tonnes of steels products. At the moment, there is no sign that mills will reduce output given the margins they enjoyed. Going forward, unless we see a fall on production, it is hard to see a bright uptick on the steel prices.
Physical traders do not trade as frequently as derivatives investors. In last year, most of them have simply follow the strategy of “buy and hold”, from the thin market volume. In this way, they had successfully helped to lift the prices. From last Q3 to March 2017, we can hardly see significant price correction on physical as well on derivatives. This suggested that physical buyers have a unified expectation on the price to reach a better level. However, due to liquidity issue, they are in a state of panic to find a buyer. From end-users’ point of view, the demand is still stable, with that many sellers that short-termly cannot match with equal amount of buyers – so inventories are discounted to the market.
Vehicles: Currently, it is a busy season for auto-makers in China, since there are many large-scale auto-shows being held at almost everywhere from April to June period. China’s statistic indicated that during this period, auto-sales accounted nearly 1/3 of the entire fiscal year. As a developing country, the current average vehicle ownership per capita in China is less than 0.7, which is still low even compared to some under-developed countries. Thus in short, there are still lots of room to grow on the automobiles demand in China.
Housing: there is an interesting relationship on the housing and land policy in China; when housing prices rose, the Chinese government will introduce regulation to restrict on the purchase of houses. But at the same time, the authorities will speed up in making more land supply for urban development. Therefore, FIS viewed that the real demand on building materials will only matters when the construction activities were built on the new lands.
Projects: The major projects mentioned in China’s National People Congress have been silent for some months. Nevertheless, the Chinese authorities will push for these projects characteristically to follow their construction schedules and these will drive up the expected demand of steels till Q4.
The worst case scenario for the market is that steel-makers have already purchased iron ores at order-basis and keep a low inventory turnover of 25 days for Q2. In this circumstance, the mismatch on last year of demand against supply would not happen, prompting less prices movement in the seaborne market. Then, the mills will depend on the high inventories of high grade ore stocked at the Chinese ports, which may last them for six months before steel-makers re-emerged in the seaborne market for procurement.
The best case scenario is that the total demand of steels is huge and at an ever-increasing manner. This will be good news for the big miners, as they could stop the shipments for weeks, which would be enough to raise the price of iron ore artificially.
In conclusion, we would expect the price of iron ore to hover around $50-60 for the next quarter. In the meantime, the market is unlikely to hit in an “off-season” for steels and ores in Q2 due to the seasonal construction activities boom in China.