COLUMN-Is China's economic cart before iron ore horse?: Clyde Russell

Thu Mar 13, 2014 2:21am EDT

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--Clyde Russell is a Reuters market analyst. The views expressed are his own.--

By Clyde Russell

LAUNCESTON, Australia, March 13 (Reuters) - Conventional thinking is that iron ore prices have plunged this year because of concerns about China's economic growth outlook, but it's possible the reverse is the case.

The 16 percent drop in spot Asian iron ore .IO62-CNI=SI between Feb. 17 and March 10 is more than likely a cause of concern about China's economy, rather than a symptom of malaise in the world's biggest commodity consumer.

While this sounds like a chicken-and-egg debate, if one views iron ore's decline, along with similar falls for copper, as raising concern about China, then looking at the dynamics behind the decrease in prices can be illuminating.

The reasons most often cited for iron ore's drop are a weakening steel demand growth outlook in China and an increase in available supply.

There is truth in these arguments, but they are far from complete explanations.

On the supply side, it's true that Australian miners have increased output, and more supply is expected in the next few years from both Australia and number two exporter Brazil.

But so far they have been able to sell all of their output, and while traders say the market is well supplied, there isn't much talk of significant oversupply driving down prices.

On the demand side, China's steel output has recovered, rising 5.9 percent to 2.08 million tonnes a day in the last eight days of February from the preceding 10-day period, according to the China Iron and Steel Association.

This is also up from the 2.07 million tonnes daily average for 2013, showing that the output is still growing.

Steel inventories remain near record highs, although they have declined recently, dropping 5.9 percent to 16.3 million tonnes at major mills in the last week of February.

The steel data suggests that iron ore demand should remain solid, and the risk of an unsustainable rise in steel inventories seems to be reducing, especially with the major construction season coming in the next few months.

So, why have iron ore prices fallen so sharply to put them down 20 percent now since the start of the year?

INVENTORIES RISE, PRICES FALL

One likely explanation is the rapid rise in inventories at Chinese ports SH-TOT-IRONINV, which reached a record 105 million tonnes in the week to March 7.

Since the start of 2012 there has been a strong inverse correlation between iron ore inventories at Chinese ports and the spot price.

When the inventories reached a 2012 high of 101 million tonnes in July of that year, prices started to tumble, eventually dropping 36 percent from July 10 to its low of $86.70 a tonne on Sept. 5.

Prices then started to rise as inventories started to decline, peaking at $158.90 a tonne on Feb. 20 of last year, while inventories bottomed at 74.9 million tonnes on April 26.

What followed was a period of relative stability for both prices and inventories, but when the latter started to rise sharply from August last year, prices eventually responded by starting a downtrend in early December.

Why did iron ore inventories rise so quickly? Partly because prices were declining, but also because of the advent of using the steel-making ingredient as collateral in financing deals. As much as a quarter of current stocks are said to be tied to these credit deals, which had previously been based mostly on copper.

Recent reports suggest that the authorities are keen to crack down on this practice, and they also want to lower credit extended to uncompetitive steel mills in a bid to force a rationalisation of the overcapacity plaguing the sector.

If this is the case, it does suggest that iron ore prices may have further short-term downside as the inventories are sold off to repay financing.

The rationalisation of the steel industry is likely to be a positive for imports, though, as they tend to be of higher quality than domestic iron ore and offer better economics to more modern producers.

Also, rationalisation of the steel sector is probably not as critical for iron ore demand as might be feared.

China plans to cut about 60 million tonnes of steel capacity by 2017, which is about 6 percent of the more than 1 billion tonnes the industry can currently produce.

Given steel output in China is forecast to rise some 3 percent to 810 million tonnes this year, there is clearly room for much deeper cuts to get rid of inefficient capacity.

Lower iron ore prices also tend to force high-cost domestic miners to idle production, another positive for import volumes, if not prices.

It's also worth noting that lower iron ore prices are ultimately a positive for the Chinese economy, and will help restore the health of the steel sector.

A further sign that iron ore prices may be near the bottom is the shape of the curve for swaps traded in Singapore <0#SGXIOS:>.

This has recently seen an easing of backwardation so that it's currently relatively flat from the third month to the 12th.

When prices are poised to fall, the backwardation generally increases; likewise when they rise, the curve generally moves into contango.

Currently the flat swaps curve is suggesting a period of price stability.

The important things to note are that while there are short-term factors driving the iron ore market, the overall outlook remains for rising imports by China - with the prices determined mostly by how much new supply global miners make available. (Editing by Tom Hogue)

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