--Clyde Russell is a Reuters market analyst. The views expressed are his own.--
By Clyde Russell
LAUNCESTON, Australia, Jan 21 (Reuters) - If you want to see why Chinese steelmakers are feeling the pinch, a graph showing steel prices against those for Asian iron ore provides an easy answer.
Benchmark Shanghai steel rebar fell to a record low of 3,408 yuan ($560) a tonne on Jan. 21, continuing a weak start to 2014.
But the real story for the Chinese steel sector is that prices have lost ground every year for the last four, falling a total of 36 percent from the end of 2009 to the end of last year.
In contrast, spot iron ore prices gained in two of the previous four years and are cumulatively up 13.5 percent over the period.
Iron ore has weakened recently, hitting a six-month low of $124.80 a tonne on Jan. 20, but the simple truth is that you'd rather be a low-cost iron ore producer than a Chinese steel mill.
China's steel industry is battling to make profits, with the number of loss-making companies rising to 20 in November from 18 the prior month, according to data from the China Iron & Steel Association (CISA), which represents more than 80 major producers that account for about 80 percent of the nation's output.
The current poor profitability at mills follows a disastrous 2012, when profits fell 98 percent from the prior year and CISA said its members' combined profits were 1.6 billion yuan, a paltry amount for the world's biggest steel producer.
It seems unsustainable for the industry to continue to make losses, especially if the cost of a major input such as iron ore manages to keep increasing in price over the longer term.
The question is how is the situation likely to resolve itself, and the answer is likely a combination of factors will come into play.
The first is that Chinese steel output will grow modestly in 2014, with CISA estimating a 3.1 percent gain to 810 million tonnes, down from the 8.2 percent increase in 2013.
Secondly, excess capacity may start to be cut, with plans to close older and more polluting mills gaining pace in recent months.
The government announced plans in October last year to reduce steel capacity by 100 million tonnes by end-2015, and Hebei province, the biggest steel-making region, aims to cut 15 million tonnes of steel output this year.
These cuts may not be enough by themselves to tighten China's steel markets significantly, but they will make a dent in the surplus of product, and this may lead to more stable prices.
Steel demand is also likely to grow in 2014, and may even expand at a faster pace than output, especially if steel-intensive industries such as rail investment continue at anything like the 24.5 percent on-year increase recorded in December.
For iron ore, 2014 may finally be the year when additional supply weighs on the market.
This was expected last year, but China's 10 percent surge in imports to a record 820 million tonnes was enough to keep prices buoyant.
While imports are likely to rise again in 2014, the pace of growth should slacken to become more closely aligned with the rate of steel output growth.
However, this doesn't necessarily mean iron ore prices will decline substantially as major producers may choose not to utilise all their additional capacity.
This is especially the case for the top producers in the iron ore belt of Western Australia state, Rio Tinto and BHP Billiton.
While iron ore prices are likely to continue to soften into the Lunar new year holidays at the end of this month, it's also likely they will recover thereafter.
Spot iron ore prices are declining currently as China's port stocks are ample at around 88.5 million tonnes, a figure that ANZ Banking Group's commodity research team points out is almost 19 million tonnes higher than at the same time last year.
Inventories are currently being run down, meaning steel mills are likely to be more active buyers after the week-long holiday.
Certainly, the iron ore swaps curve in Singapore isn't signalling that prices will decline significantly.
The six-month contract is currently 9.1 percent below the front-month, slightly wider than the 8.1 percent that prevailed when the current downturn in prices started early in December.
The steeper the backwardation, the more likely prices will continue to weaken, so the curve is pointing to further weakness, but not a collapse.
In contrast, the curve tends to flatten and may even move into contango just prior to rallies, as happened in June last year, when the six-month contract was just 1.7 percent below the front-month.
It's too early to say whether steel prices can outperform those for iron ore in 2014, but if the Chinese can reduce capacity, even moderate demand growth should result in a positive year for prices.