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--Clyde Russell is a Reuters columnist. The views expressed are his own.--
By Clyde Russell
LAUNCESTON, Australia, July 1 (Reuters) - Iron ore prices rose the most in 10 months last week, but hopes that this marks the start of a new bullish phase are likely to be dashed.
Spot Asian iron ore .IO62-CNI=SI ended last week at $94.90 a tonne, a gain of 3 percent from the prior week, with prices bolstered by an improvement in the outlook for manufacturing in China following the June HSBC flash Purchasing Managers' Index showing expansion for the first time in six months.
Iron ore prices are still down 30 percent from the $134.20 a tonne at the end of 2013, but they have recovered since briefly dropping to a 21-month low of $89 on June 16.
The bullish case for a recovery is largely based on expectations that Chinese domestic production will drop as high-cost mines are forced to close on unsustainable losses.
The loss of domestic output will open the door to increased imports, thus absorbing the extra supply being brought online by the major mining houses.
This view is bolstered by the improving outlook for steel demand on the back of faster investment in railway and other infrastructure spending as the authorities undertake what's been characterised by several analysts as a "mini-stimulus" to ensure economic growth remains above 7 percent per annum.
It does appear that Chinese iron ore mines are closing, with industry website mining.com reporting on June 30 that 20 to 30 percent of domestic mines have been idled, citing the China Metallurgical Mining Enterprise Association.
Domestic output accounted for about 30 percent of last year's iron ore demand in the world's largest consumer of the steelmaking ingredient, equivalent to about 350 million tonnes of 62 percent iron ore, the global benchmark.
According to a Morgan Stanley research report on June 12, about 46 percent of this is produced at state-owned mines and the rest at private operations.
The weighted average cost of state-owned mines is $82 a tonne and about $101 a tonne for the private companies, Morgan Stanley said.
State-owned mines are likely to continue producing even as prices fall, given they are more focused on jobs than profits and many are integrated with steel mills, the report said.
However, private mines will idle some output, with Morgan Stanley estimating 64 million tonnes of 62 percent iron ore equivalent could leave the market in 2014.
But this still won't be enough to offset increases in supply, with the report saying an extra 111 million tonnes will be added this year to seaborne supplies by the big four global miners, Vale, Rio Tinto, BHP Billiton and Fortescue Metals.
Another point worth noting is that if private mines in China have a weighted average cost of about $101 a tonne, this suggests they will return to full production if the price rises significantly above that level.
This implies that the spot price should remained anchored around this level for the medium term, as a fall below knocks out some Chinese output but a rise above brings it back.
Another factor cited by those expecting iron ore prices to rally is reports of low inventories held by steel mills, meaning they will have to enter the market to replenish stocks.
The flip side to this is high inventories at Chinese ports.
While these did decline to end last week at 112.65 million tonnes, this was from the prior week's record 113.65 million, and it will take some time before inventories return to more normal levels of around 80 million tonnes.
Another positive price factor being currently cited is the switch to contango from backwardation in the Dalian Commodity Exchange iron ore futures curve <0#DCIO:>.
The second-month contract was at 676 yuan ($109.04) a tonne in early trade on Tuesday, while the six-month was at 690 yuan, a premium of 2 percent. A month ago the six-month futures was at a discount of 4.9 percent to the second-month.
The switch to contango does support the view that prices are unlikely to fall much further, but whether the curve has yet steepened enough to point to a sustained rally is doubtful.
What the short- to medium-term outlook for iron ore comes down to is this: will enough Chinese domestic output leave the market to absorb additional global seaborne supply?
So far, it doesn't seem that much Chinese output has actually been shut in, with official data actually pointing to an increase in the first five months of the year.
Iron ore output was 131.943 million tonnes in May, up 12.7 percent from April, taking the year to date output to 568.48 million tonnes, a gain of 10.7 percent.
For the bullish case on Chinese domestic mine shutdowns to be valid, the data for the next few months will have to show declining amounts of iron ore being mined.
On the bearish side, it seems clear that the low-cost big four miners will continue to produce as much as they can while seeking to lower costs.
This confirms the view that the seaborne market is moving to a structural surplus, a position reinforced by reports that both Australian miners and Brazil's Vale are offering discounts to Chinese buyers.
There are merits to both bullish and bearish views on iron ore prices, but the balance of risks seems more in favour of rallies being selling opportunities, given the supply overhang that now exists. (Editing by Muralikumar Anantharaman)