Dry Bulk Derivatives – 2017 Mid-Year Report


Iron Ore – Despite a fall in prices in May and the build up of port stocks, iron ore continues to attract strong trading which is increasing open interest

Steel Margins – Producers switching to HRB production may find that current profit levels are not sustainable over the longer term

Coking Coal – Returning profitability but high stockpiles could put prices under pressure

Freight – Scrapping has fallen and new orders increased but market has the potential to find support

Iron Ore and Steel Products

Iron Ore Resilient

Dalian Iron Ore prices doubled between last September to February 2017, before experiencing a three month correction, and giving back all gains in May. Inventories at the 45 major ports totaled 100 million tonnes in last September and reached over 140 million tonnes in Q2. However, steel production did not see a sharp increase over the same period of time, rising from around 95 million tonnes to 99 million tonnes per month. The bad news concerns exports which are down 40% for the first five months in 2017. However by June, the investment sentiment in the commodity market was warming up.

2H Outlook Chart 1Chart 1: Iron Ore Supply – Demand Surplus (Data retrieved from MySteel, compiled by FIS

From the supply-demand analysis, the iron ore surplus has become less significant since a certain proportion of supply will be counted as replenishment for the potential increase of steel making. Deliveries by the major miners are little different from last year, at a period of time when demand is strong and prices falling with stocks indicate the market has entered a destocking period.

The 2016 annual report of Australian miners indicates their total costs plus freight, port charges and including VAT and exchange rates is around $35 thus the current market price of $55–60 does not threaten deliveries. Chinese miners have controlled their costs below $65, meaning domestic mines are intending to compete with seaborne ores.

The Steel Market

The tables below include data on iron ore and HRB futures from Jan 2014 to June 2017.

2H Outlook Table 1Table 1Futures Statistics (Data retrieved from MySteel, Shanghai Futures Exchange, Dalian Commodity Exchange, compiled by FIS)

The HRB inventory-sales ratio in May shows a historical low, and creates a physical–futures basis around 600–700, which could potentially pull back to a normal range of around 300. For now, the high profit and big discount on futures are supporting the HRB price.

In terms of statistical arbitrage, the HRB/Iron Ore ratio reached a record high by exceeding three standard deviations from the average which indicates a large imbalance between material price and finished good price. Because profit on HRC is far less than current billet margins, many HRC producers are transferring production to HRB. HRC/HRB futures achieved -170, the lowest ever recorded.

Research from MySteel counted 204 production lines manufacturing HRB, 72 HRC and 58 CRC. Thanks to limited production capacity, HRC and CRC have maintained a stable utilization rate over 80% and while HRB has a bigger capacity, the low utilization rate is partially due to mill closures. Given the potential for utilization increases, it is expected that HRB will enter a new phase of diminishing marginal profit, with prices falling.

Meanwhile, the ratio of steel scrap content in Electronic Arc Furnace (EAF) divided by steel scrap content in converter furnaces (the majority steelmaking technology in China), was 0.32 in 2015 and 2016. This ratio climbed to 0.36 on 2017, indicating the scrap steel usage in EAF is increasing. The usage of steel scrap is benefiting from an increase of amount in both converter and EAF capacity.

However, since most converter furnaces have already maximized their scrap steel input, the potential increase from converting more furnaces limited and scrap will have limited impact on pig iron as a substitute.

Ferrous Sector Risks

In terms of the ratio of trading volume to open interest, iron ore has the smallest number over the past three years, indicating there is less speculation compared to other products. Coke trading is more speculative, as a result of lower deliveries and a smaller market, so big players have the opportunity to make an impact on the market.

Sales on ferroalloys were boosted from 2016, the price is strong on futures market and trading volume is growing as well. From a seasonality perspective, speculation emerges from April to May and October to November. These months are just before June and December, with a high possibility of a ’cash crunch‘.

Frequent speculation on the market is likely to create a periodic trend. Arbitrage normally narrows the deviation when the price has gone too far in one direction. Also worth mentioning is that HRB, HRC and Iron Ore have witnessed historical peaks of open interest. HRB has grown from 69% open interest from the same period over last year, and iron ore increased by 34%. Manganese Ferrous trading volume grew 9 times year-on-year and open interest increased five times, exceeding coking coal in terms of lots.

2H Outlook Chart 2Chart 2: Trading Volume/Open Interest Ratio Ferrous Sector (Data retrieved from: Shanghai Futures Exchange, Dalian Futures Exchange, compiled by FIS)

From empirical analysis, the contango structure or a much narrowed spread close to zero will not last. The current price of physical ores are some way from the CFR cost to Northern China, as well as the diminished C1 cost from miners plus freight, which are all factors to maintain the mechanism of backwardation market.

The HRB October contract onshore reached 3400–3500 in July, a periodic high that was rejected three times from last year. A breakthrough on this area is inspiring the confidence on a new round of buying, which will benefit the ferrous sector as well.

The major risk in ferrous sector is the huge open interest, indicating a high level of speculation compared to very limited deliverable volumes. As result, covering activity is the major force to drive the trend before the active contract rolling during Q3.


Booming auto sales in China between December 2016 and the 2017 Lunar New Year suggest an expected replenishment of plate steels around November thus year. The second replenishment cycle for building materials typically happens in China from September to October.

Both glass and cement show balanced inventory and currently stand in a growth phase. Activity in construction-related sectors have served to validate the price of steel and is marked by real demand.

The degree of speculation in iron ore derivatives has fallen greatly year on year, which has lowered volatility among different products. As a result, a cross-exchange or cross-products arbitrage requires a day-to-day back test on the proportion of each contract. However the statistical data shows the HRB/Iron ore spread is overbought, suggesting there is more probability of winning from short-term buying. Time to maturity and contract rolling are risks for this strategy.

Because monetary leverage has narrowed during a cycle of interest rate increases, physical traders have limited cash available to manage their inventories and thus less patience to wait for a long trend. However, supply-side reform is benefiting the profit on steel making and trading, thus benefiting the price of steels and all ferrous products. The price expectation for physical iron ore and current month futures is around $55-$65, though the painful fact is that a market consensus does not dictate its direction.

Coking Coal and Coke

A Tug of War on Bargaining Power

Coking coal prices have rebounded 26% from the periodic low during June which began at the end of May. Domestic coke mills have experienced mergers, restructuring, liquidation and securitization between April and May as coal mining industry reforms took place. Australian prime metallurgical coal currently has a price advantage over Tangshan product however traders and mills are waiting for lower prices to increase their import options.

Chinese imports of metallurgical coal totalled 30.20 million tonnes in 1H 2017, increasing by 42% from the same period of last year. Railway transport volumes totaled 698 million tonnes between February and May, (583 million tonnes in 2016) however steel mill inventories are only half the level of last year. However, port inventories are larger than last year, indicating less seaborne coal is consumed compared to domestic coal.

2H Outlook Chart 3Chart 3: Inventory Turnover in Days from sample Independent Coking Mills and Steel Mills (Data retrieved from: MySteel, compiled by FIS)

The chart above shows a survey of inventory turnover from sample steel mills and independent coking mills, indicating that inventory turnover has reached a five-year-low of 13 days. Currently coking coal is experiencing a fall in both inventories and prices during a destocking cycle. Given that the price is standing at a high level, the equilibrium of supply and demand is maintained by the high consumption of furnace materials.

A Closer Look at Coking Profits

An early indicator that coking profits are returning is that the ratio on Dalian coke/coking coal futures climbed to 1.55–1.6 in May and June 2017 from around 1.35-1.4 over the past few years. However, current coking profits are unsustainable, since either the falling price of iron ore or the narrowing steel mill margins would lead to a drop in coking profits.

Dalian Coking Coal futures open interest has grown from 21.75 million tonnes to 24.84 million tonnes in Q2. This suggests the coking coal market is attracting new money inflows though at the same time, the seaborne market has a bigger potential to follow the evolution of iron ore since the volume is not overheated at this point.

2H Outlook Chart 4Chart 4: Coking Profit (Data retrieved from: Dalian Commodity Exchange, compiled by FIS)


Considering the tight inventory on standard coking coals and PCI with high stockpiles of prime coking coals at the ports, the coking coal swap may face some pressure. Dalian coking coal, however, is relatively strong and long-term, new technology processes will aim to decrease the coke ratio from an eco-friendly perspective. The low inventory this year will not cause a geographical or temporary shortage.



Strong Iron Ore Volumes Still to Come

The freight market is in the process of rebounding from the historical lows of 2016 with Capes and Panamaxes recording periodic highs in Q1 before falling though in most circumstances, Capes have maintained a premium to Panamaxes. Scrapping of Capes fell by 63% between Q1 and Q2, with new orders only showing up in May. Panamax scrapping has decreased by 32.3% while there has been a very stable flow of new orders. These numbers might help to explain the negative spread of Cape–Panamax during mid-May. There are always some opportunities to arbitrage the spread when this goes to an extreme range.

Cargo volumes in Cape and Panamax started to expand from Q2 2010 where the recovery of emerging markets in Asia spurred demand for iron ore, with Capes carrying much of the weight ever since.

Australia and Brazil have completed less than 40% of scheduled deliveries of iron ore, leaving large potential delivery volumes in H2 2017. Prime metallurgical coke and coal are becoming cheaper than the domestic products, however India will soak up a lot of coal and ore supply because the country has entered a new stage of developing infrastructure.

In both the Gulf Coast and Chile area, the weather conditions in H1 2017 were softer than in past years and as a result, the deliveries of soya beans has not been influenced. Shipbuilding prices have increased by 4.9% for Handymax, 1.7% for Panamax and less than 1% for Cape and the newbuilding price for larger ships is more limited since fewer new orders were placed compared to last year.

2H Outlook Chart 5Chart 5: Thermal Coal, Iron Ore and Coking Coal Import (Data retrieved from: MySteel, compiled by FIS)


In short term direction of two key indicators – fuel oil and the Baltic Dry Index – are diverging as the high cost of bunkers has weakened the marginal profit of freight. In the longer term, counted over one year, the two variables may converge, because the price change has converged to the cost of freight.

Prospects for the Capesize freight market depend to a large extent on the miners’ completion of iron ore deliveries in H2 2017, as well as coking coal export volumes. To maintain the perspective of Q1, the turning point has arrived, indicating the market has potential to find support.


Research Analyst Hao Pei Tel: +8621 63354003 E-mail: haop@freightinvestor.com

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