Iron ore braces for plateauing Chinese steel output

The dramatic decline in seaborne iron ore prices has grabbed headlines in recent weeks but tectonic shifts may be underway in China, paving the way for a new normal for the raw material.

The elephant in the room is the property sector, one of the pillars of steel demand. Talks are rife that China is earnest in its desire to tame the debt levels of property developers. This is to align with the goals of cooling off property sector prices and the government's "housing is for living" rather than speculation approach. This goal is not new. China has talked about the need to cool its property market for years.

Imminent among the concerns is the fate of Chinese developer Evergrande and whether the government will provide a path to bail it out. Many participants attributed a 20 September sell-off in financial markets to Evergrande's debt concerns. Shares of Rio Tinto, the top iron ore producer, are trading around 28pc below this year's peak. Markets have recovered since Monday, with Singapore Exchange iron ore futures regaining most of the losses on 20 September by the time of writing.

Why is Evergrande significant?

It is China's top property developer. The real estate sector accounts for around 40pc of China's steel consumption. The company's debt problems are not new and the question of whether it is too big to fail have been asked over the past few years.

It is in the news now as an interest payment on a bond is due this week, with another payment due on 29 September. The bonds would default if the company fails to make the payment and increases risk of a larger contagion. When giants fall, the market's risk appetite retreats.

Why is iron ore falling?

Physical iron ore prices have not moved so far this week with China on holiday for the mid-autumn festival.

But iron ore prices have been on the decline for the past weeks because of steelmaking cuts in the country as China looks to control output. The Evergrande crisis and its looming payment test are not why iron ore prices have shed their gains, with the month-to-date average down by 0.1pc versus September 2020 average. Evergrande's fate though could be a harbinger of whether China walks the talk on managing debt levels of its property sector. A boom in the Chinese property sector over the years has worked to the advantage of iron ore and steel demand, with developers able to borrow even ahead of finishing projects and amassing massive debt that leaves the wider financial system, including investors and banks exposed. The government wants to change this. A reined-in property sector will have a bearing on demand for steel products, especially rebar.

Will iron ore continue to fall?

Spot market prices will always react to supply-demand dynamics. China's iron ore imports have been rising consecutively over the past decade. This year marks a watershed moment in that the efforts to tame crude steel production are likely to bring 2021 annual production on a par or even below last year's 1.06bn t. That leaves the question of steel demand.

Iron ore and steel prices have previously moved in the same direction as curbs on steel output have lifted mills' margins. This year, the margin pressure is maintained by the record rise in metallurgical coal prices. Notwithstanding coking coal, mills are cutting production due to policy requirements. A draft autumn-winter pollution controls plan has called for cities in northern Hebei and Shanxi, east and south Shandong and some in the south of Henan to be brought under controls. This is over the emissions controls typically seen during the 1 October-1 March period across Beijing-Tianjin-Hebei and the neighbouring 2+26 cities, alongside the Fenwei Plain area.

The market has little wriggle room to respond to any natural resetting of supply-demand dynamics as a result. The taming of the property sector will cut demand for rebar products that are often considered lower on the steel value chain as they can be made with comparatively less value-addition than flat steel products. This aligns with the growth trajectory of developed economies. Producing high value-add products allows countries to capture a bigger share of the product's price. Further declines in iron ore prices will be a function of Chinese steelmaking cuts through the rest of the year and any iron ore supply disruptions.

Supply disruptions are harder to predict, but the top-producing countries Australia and Brazil are out of the seasonally weaker shipment periods. Supplies from Australia were under pressure in the first half of the year on weather and logistics issues, while market participants have recently flagged the tight availability of Brazilian Iron Ore Carajas fines as why the grade spread is supported despite overall weakness in iron ore demand.

Earlier this month, Vale said it expects to reach a production capacity of 370mn t/yr by the end of 2022, down from a previous target of 400mn t/yr. The announcement was met with silence from the spot market, which deemed it too "long-term" a factor to consider but it highlights the persistent risks to supply estimates.

Supply-demand response

As Chinese steel production plateaus and arguably its iron ore demand stagnates, who could take up China's share of iron ore demand?

Developing economies like India and Vietnam typically have an insatiable appetite for steel. India has a massive iron ore appetite to feed its annual crude steel output of around 100mn t, with the potential to increase the blast furnace-basic oxygen furnace production route that stood at 45pc in the year ended March 2021. But India has sufficient reserves domestically.

Vietnam's annual crude steel production of some 20mn t may not be enough to redirect trade flows for iron ore. In the short term, robust ex-China pig iron production amid governments' stimulus packages will be a demand driver as China pulls back. The decline in iron ore prices, which are benchmarked on cfr China levels, may be visible first in the iron ore supply chain with high-cost miners likely to scale back.

By Deepali Sharma