COLUMN-Supply may not be iron ore market's biggest problem: Andy Home

Fri May 16, 2014 9:29am EDT

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(The opinions expressed here are those of the author, a columnist for Reuters.)

By Andy Home

LONDON May 16 (Reuters) - "We expect that the price in the second half will be better than the first half. One thing is for sure, the price will not go below $110 on a sustainable basis. I think we have many times seen the price going below this level, but recovering very fast."

So said José Carlos Martins, executive officer of ferrous and strategy at Vale, the world's largest producer of iron ore, speaking on the Brazilian company's Q1 analysts call.

The spot price of 62 percent iron ore, as assessed by the Steel Index .IO62-CNI=SI, stood at $102.80 per tonne on Thursday.

That doesn't make Martins wrong.

Since 2009 the iron ore price has slumped through that level on only a couple of occasions, most dramatically in the third quarter of 2012 and again in March this year. On each occasion the market was in panic de-stocking mode and, sure enough, the price quickly recovered.

That March rebound has faded quickly, however, and here we are below the "magic" number again.

So should we expect another quick bounce, as Vale and its producer peers argue?

Or is this market collectively ignoring the elephant in the room that is the weakness of the single most-important driver of steel demand?

THE "MAGIC" NUMBER

The existence of a magic number below which the price of iron ore cannot sustainably stay is widely accepted, although there are as many magic numbers as there are analysts.

But most think that it's there somewhere in the $100-120 per tonne range.

Iron ore is by no means unique in this regard. Indeed, the concept of a floor price is common to every commodity market suffering from oversupply or heading towards oversupply.

Iron ore is in the latter category. Until this year the world's producers simply weren't digging enough of the stuff out of the ground to meet demand from China's huge steel sector. The result was a tripling in the price from the start of 2009 through to the middle of 2010 and a subsequent period of sustained high prices due to continued supply shortfall.

Now, however, Australian producers in particular are cranking up production to the point that 2014 is widely expected to be a year of significant oversupply.

In an oversupplied market, the price should in theory come down to a level at which higher-cost producers exit, forcing a rebalance with demand. In the case of iron ore this primarily means squeezing out smaller Chinese producers.

There are lots of potential variables that can affect the rebalancing process, from the speed at which new supply comes on stream to the natural reluctance of those that should close to actually make the decision to do so.

In short, the price can and often does stay below the magic number for longer than many expect before supply-demand equilibrium is re-established.

But that doesn't negate the validity of the idea that production costs will over time define the downside of any surplus market.

STEADY AS SHE GOES?

Of course the size of that surplus holds the key to how much higher-cost production must be forced out and at what price.

Hence the current focus on how the big expansions in Australia's Pilbara are faring. Very well, in the case of the big three producers, Rio Tinto, BHP Billiton and Fortescue Metals, which has caused some analysts to adjust their time-lines.

Forgotten, though, in this current fixation on the supply side is what is happening on the demand side of the iron ore equation.

Even with multiple signs of recovery in steel demand in the rest of the world, it is China that holds the key. How could it not, given the country accounts for almost half global steel production and a still higher proportion of demand for seaborne iron ore?

And superficially things look OK, or as OK as they could be given the bigger story of Chinese growth slowing as Beijing presses on with its policy of re-engineering growth away from fixed asset investment towards a more consumerist model.

China's steel sector is moving up through the gears. National output hit record run-rates in April and that momentum continued into the first part of May . Inventory levels are falling across the steel products spectrum.

All of which chimes with the "usual" strength of the Chinese steel sector at this time of year, characterised as it is by a resurge in construction activity after the Northern Hemisphere winter months.

Chinese steel demand growth may be slowing but it is still growing and that's everyone's base-case scenario when it comes to assessing the size of likely surplus in the seaborne iron ore market this year.

THE ELEPHANT

There's just one small warning light flashing.

China's exports of steel products hit 7.54 million tonnes in April, the highest level since August 2008, a telling reference point since that was the time the global financial crisis was fast morphing into global manufacturing crisis.

It's the third time this year that exports have soared past the 6.0-million tonne mark. The cumulative year-to-date total of 25.87 million tonnes is up almost 30 percent from last year's equivalent level.

As analysts at UBS bank point out, April's net exports of steel products were equivalent to an annualised 75.92 million tonnes, or one year's worth of Japan's crude steel domestic demand. ("UBS Global Signals", May 9, 2014).

That so much material is seeping out of China at what should be a seasonal high point for its own demand is telling.

And it's not hard to figure out what the problem is. Just about every signal coming out of the country is pointing to trouble in the construction sector.

Prices are down, sales are down and new construction is down.

As analysts at Macquarie note, "the state of the real estate market in China is possibly the most discussed variable amongst those trying to gauge the demand outlook for commodities".

The bank's research note of May 13 is titled "China's real estate market: riding out another cycle", which sums up Macquarie's view that the current weakness in the sector is cyclical not structural.

Not everyone would agree. Analysts at CHR Metals have been warning for some time about China's property "bubble", noting that official figures may be understating the scale of price falls outside of major cities. ("Global IP Watch", April 2014).

"There are numerous reports of developers unable to repay loans and this has consequences for construction companies, construction material producers and equipment makers all of whom are likely to be owed money," they said.

And, of course, the steel supply chain within China, dominated as it is by traders.

Remember that the March mini-rout in iron ore was triggered by stresses running along the multiple credit fault-lines linking iron, steel and construction sectors.

China's construction sector is the single biggest driver of global steel demand and therefore of iron ore demand.

It is the elephant in the room in a market which is now obsessing about supply. If unleashed, it could trample all over everyone's magic support numbers.

If that sounds like scare-mongering, consider another little flashing warning sign.

Today the price of Shanghai rebar, the steel product most used in construction activity, touched its lowest point since the contract was launched in March 2009.

Hear that sound? Is it just me, or does that sound like an elephant approaching?

(Editing by Pravin Char)

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