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COLUMN-Record Chinese steel output rests on record speculative interest: Andy Home
July 17, 2017 / 2:13 PM / 3 months ago

COLUMN-Record Chinese steel output rests on record speculative interest: Andy Home

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

* Shanghai Steel Rebar Contract: tmsnrt.rs/2v9WUy7

By Andy Home

LONDON, July 17 (Reuters) - Another month, another Chinese steel production record.

China’s giant steel sector churned out 72.78 million tonnes of the stuff in June. That was equivalent to annualised production of 891 million tonnes.

The previous monthly output record was set in May 2014 at 71.16 million tonnes. This year, however, that historical landmark has been exceeded in every month since February.

There may be some statistical smoke and mirrors at work behind this record-breaking production run.

But the underlying reality is that China’s steel mills are being incentivised to lift production rates by strong prices. That of Shanghai steel rebar, used primarily in the construction sector, was last week trading at levels not seen since the end of 2013.

There are solid fundamental foundations for this price performance.

But there is a lot of speculative money in the mix as well with open interest on the Shanghai Futures Exchange’s (ShFE) steel contracts also notching up fresh records on a near daily basis.

Beijing is no doubt keeping a wary eye on the Trump Administration’s national security investigation into imports of foreign steel, but the most pressing threat to China’s steel producers might be the country’s own investors.

CAPACITY DOWN, PRODUCTION UP

The strength of China’s steel production might appear strange, given the government’s efforts to close outdated, polluting capacity.

Beijing claims to have phased out 65 million tonnes of capacity last year and another 42 million tonnes in the first five months of this year.

As such, it’s well ahead of its stated five-year target of closing between 100 and 150 million tonnes.

So how come the country is producing record amounts of steel then?

Because the official capacity closure targets come with two important caveats.

The first is that a significant part of what has been “closed” wasn’t actually producing steel anyway. Dismantling older, unutilized production lines has been an easy way for China’s steel producers to tick Beijing’s supply-side reform boxes.

Secondly, the official targets don’t include the elimination of what the Chinese call “DeTiaoGang”, substandard steel, particularly rebar, produced by smaller operators using scrap rather than iron ore as a feed.

Since Beijing classifies “DeTiaoGang” as illegal, unapproved capacity, it does not count towards the official capacity cut targets.

And crucially, it has never been included in the official production figures either.

Its unofficial status means that nobody knows for sure how much “DeTiaoGang” is produced but the consensus estimate is that it is definitely more than 100 million tonnes per year. To put that figure into context, China’s official production last year was 808 million tonnes.

What this means is that part of the current strength of Chinese steel production is a statistical illusion, official countable output rising to fill the gap left by the closure of unofficial, uncounted output.

STRONG FUNDAMENTALS...

The authorities claim to have closed 600 “DeTiaoGang” steel producers with combined capacity of 120 million tonnes in the first half of the year.

The stated aim is to completely eliminate all such “backward” capacity by the end of this year.

The effectiveness of the ongoing clamp-down seems to have led to pockets of tightness in the domestic steel supply chain.

Even with production running at record levels, there has been no discernible build in steel inventory in the country and exports remain subdued, falling by 28 percent, or 16 million tonnes, in the first half of the year.

Demand from the construction sector remains robust.

The latest batch of real estate indicators out this morning showed investment in the sector slowing marginally in the second quarter relative to the first but still running at a brisk pace.

Crucially, new construction starts measured by floor area rose by 14.0 percent in June, which was the fastest rate of growth since October 2016.

Strong demand and falling supply, even if statistically elusive, go a long way to explain the strength of Shanghai steel rebar prices.

Graphic on ShFE steel rebar: price, open interest and volume:

tmsnrt.rs/2v9WUy7

...STRONGER SPECULATION

There is, however, a third element in this bullish steel cocktail.

Open interest on the Shanghai rebar contract has also been setting fresh records.

It ended May at 4.61 million contracts, comfortably exceeding the previous end-month record of 4.0 million dating from November 2015.

By the end of June open interest had exceeded the 5.0-million mark for the first time ever. It has been holding above that level in the two weeks since.

Rising open interest has coincided with a rising price, suggesting that speculative money has come in on the long side.

Now, it wouldn’t be the first time that Chinese investors have crowd-surged into the commodities space. Such was the speculative frenzy seen in the first part of last year that it took multiple hikes in trading fees across multiple exchanges to drive them back.

This time around, however, things look a bit different.

Last year’s speculative bubble was characterised by spikes in trading volumes but with little change in open interest, a combination indicative of a day-trading crowd.

Volumes on the Shanghai rebar contract are currently high but a long way off the elevated levels seen last year.

The inference is that the speculative flows currently entering the market are both more structured and controlled by larger entities happy to leave positions in place for days if not weeks.

Something similar seems to be happening with the ShFE’s contract for hot-rolled coil (HRC), a steel product with manufacturing rather than construction applications.

The HRC contract was only launched in March 2014 and is therefore something of a little sister to the more mature rebar contract. But it too has seen open interest hit record levels above 800,000 contracts in the last couple of days.

As with rebar, the build in open interest has coincided with rising prices but with no dramatic spike in trading volumes.

BETTING THE HOUSE ON HOME-BUILDING

Chinese investors, it seems, are betting the house on more home-building and more steel capacity closures.

There is nothing right now to suggest they are wrong to do so but the size of their collective positioning in Shanghai should ring alarm bells.

Because markets don’t move in straight lines and at some stage a price correction will come. The danger is the next one will trigger a disorderly stampede for the exit door, compounding pricing weakness and sending shock waves along the steel supply chain.

It may yet be Chinese funds not the U.S. president that trump the current positive dynamic in China’s steel sector.

Editing by David Evans

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