Iron ore supply tightness set to continue
High steel prices incentivizing strong production
Iron ore prices have risen to record highs in recent weeks, largely because supply has not been able to keep pace with demand in China, where crude steel production has grown by 30% over the past five years.
Unless China drastically cuts steel output – which seems unlikely as Q1 output rose 16% on year – or global iron ore supply increases significantly, it is difficult to see what will cause benchmark prices to retreat to consensus views of around $100/mt in the next 12-24 months.
Iron ore prices are currently hitching a ride on the back of soaring Chinese steel prices and margins, with news of further output reductions for environmental reasons boosting an already overheated sentiment. China's domestic hot-rolled coil margin hit a record $177.80/mt on April 25, according to S&P Global Platts Analytics. Domestic HRC prices were Yuan 5,750/mt ($888.50/mt) the same day, marking a 7% climb over April.
Looking into May, the monthly Platts China Steel Trade Tracker shows the market expects steel prices to continue rising, supported by falling steel inventories and robust orders.
Often it is not clear whether steel prices are being pushed by raw materials prices, or whether raw materials prices are being pulled by finished steel prices.
At the moment, it seems to be the latter. Since 2010, iron ore and steel prices have generally trended in the same direction. An exception was 2018, when the two prices decoupled. Why?
Iron ore prices were rangebound at moderate levels for much of that year, failing to enjoy the benefits of rising steel prices. China's iron ore import volumes were slightly lower in 2018 than they were in 2017 – 1,064 million mt versus 1,075 million mt – but were more than adequate at a time when the country was removing steelmaking capacity as part of its supply-side reform agenda. Downstream, property construction demand was extremely strong in 2018, supported by shanty town renovation, while Beijing's "more active" fiscal policy saw more local government bonds going into infrastructure.
Strong steel prices as a result of capacity removal incentivized new steelmaking facilities under China's steel capacity swap program. In 2019, China added 40 million mt/year of capacity, much of which was in effect net capacity as the new steelmaking facilities were replacing ones that had been offline for several years. The capacity increase slowed in 2020, but Platts Analytics expects around 28 million mt/year of new capacity to be commissioned in 2021.
China produced 1,053 million mt of crude steel in 2020, around 245 million mt more than it produced in 2016. This is despite some 100 million-150 million mt/year of steel capacity – along with an additional 140 million mt/year of induction furnace capacity – over 2016-2020 (the 13th five-year plan) being removed as part of the country's supply-side reform.
Capex cuts, value over volume, keeping supply tight
Meanwhile, iron ore majors and other resources companies in Australia were slashing capex and exploration spending over this period. The focus was on maintaining the quality of core assets, delivering more cash back to shareholders and keeping a firm grip on the financial reins. "Value over volume" was the mantra.
Looking at where iron ore prices are currently, the iron ore majors and their shareholders would argue that this was the correct policy. But producers did not anticipate how quickly steel output would grow. Rio Tinto and BHP expected China to reach annual steel production of 1 billion mt sometime over 2025-2030 – but China achieved this in 2019.
Last year, China imported 1,170 million mt of iron ore, up around 146 million mt, or 14%, compared with 2016. Australia's total iron ore exports in 2020 were 897 million mt, just 89 million mt, or 11%, higher than in 2016. Brazil's exports last year were 396 million mt, compared with 374 million mt five years earlier, with production over the five-year period impacted by the tailings dam tragedy and subsequent recovery.
Projected iron ore supply is routinely overestimated, with Australian exports yet to hit levels that were expected by many forecasters to have been achieved 2-4 years ago. Supply this year depends largely on Vale's ramp up in Brazil, while tie-in work and commissioning at new replacement mines in Australia's Pilbara region could take longer than projected.
On the steel side of the equation, only a significant reduction in Chinese production – and subsequent drop in demand for raw materials – could take the heat out of iron ore prices. Smaller output cuts here and there merely spark a rise in finished steel prices, taking iron ore prices along for the ride given the current supply-demand scenario.
Steel prices could be slightly softer in the second half of 2021 on the back of some downstream resistance to higher prices and tighter credit conditions. This could see iron ore prices climb down from elevated levels of late April. Overall, however, iron ore prices look set to remain extremely strong.
Source: S&P Platts