About that $120 iron ore floor
Iron ore prices have breached the $120/tonne floor in recent days, something that most analysts expect can’t be sustained for very long (for reasons explained here yesterday ).
Or… can it?
Let’s look at the origin of the $120 floor theory.
Firstly, you should be aware that iron ore prices were way below that level during the 2008-09 crisis:
However, as the red line shows, the two episodes of sub-$120 pricing in the past two years were very brief.
Here’s a more recent estimate of the iron ore cost curve, courtesy of JP Morgan:
So, the sub-$120, or $125 a tonne pricing pulls out the marginal (mostly Chinese) producers from the picture, which overshoots, and then prices go back up to $120/$125.
This of course depends on a certain stability or growth in demand for iron ore – which is used in making steel.
So, about that steel demand…
UBS’s Australian resources analyst Glyn Lawcock and team returned a few days ago from their second trip to China in two months with less good news than they would’ve liked.
The message is that the government is unlikely to step up and stimulate given the economy appears to be doing ok based on recent GDP prints. But then the word on the street is that it is much tougher than what it appears.
Let’s skip to their visit to two steel mills in Tangshan in the eastern province of Hebei, which is known for its steel industry. One mill was running about 70 per cent capacity and the other, larger mill running at full capacity. Both were losing the equivalent of about $30 per tonne of steel, but felt it was better to keep producing at least for now. (Emphasis ours throughout)
No production cuts as yet, but the mills have begun to mull the idea of cuts over and they may be just around the corner , but in the meantime they are feeding their blast furnaces with lower Fe content iron ore to bring down output at the margin, but this move is more about lowering costs. The mills spoken to didn’t think a US$120/t price floor would be there this time round given the level of steel prices due to over supply.
How low would iron ore prices need to get in order for those mills to be profitable again? Lawcock estimates the two mills he visited would need further drops in spot prices of $18 – $20 a tonne to become cash break even; but that assumes no further price in steel prices. He was also told some steel mills were losing at least double the amount reported by those two mills.
So what were the steel mills saying? The smaller mill thought that the price would definitely go below US$120/t cfr based on 1) the bounce in Oct/Nov 11 coincided with positive commentary on social housing by the central government and no stimulatory comments are expected this time round, and 2) demand is weak and production cuts are becoming more likely every day the steel prices remain low;
A couple of days earlier they spoke to an unidentified iron ore trader in Beijing:
An example of how tough it is for iron ore traders who have been caught with material as steel mills look to push out their buying. The iron ore manager said that he was offered lump at RMB1,065/t incl. VAT delivered to his mill 24 hrs ago and now that same parcel is on offer at RMB965/t. A US$16/t drop in 24 hrs;
There was a tiny bit of positive news for the iron ore industry: said iron ore trader believes the low inventories could lead to a rally. Meanwhile the steel mills think that the official Chinese steel output data is lagging by a month — so some steel mills may have already cut production.
The iron ore producers are naturally paying close attention to whatever is going on in China… but going ahead with big expansion plans anyway:
The chart above is from a note from JP Morgan analysts, who write that they “generally include delays” in their assessment of iron ore output plans, but even a “more conservative” forecast still calls for 8 per cent annual growth in iron ore capacity from the big four.
UBS’s Lawcock writes that the steel mills “thought iron ore price support at US$120/t was only likely if iron ore producers cut back production”.
That would be a change of tactic . The actual strategy from the big lower-cost producers, judging from Rio’s commitment to ramp up production anyway, is to wear falling prices, push out the higher cost producers, and make up the lower prices with higher volumes.
