By James Catlin
Summary:
- 2017 can be seen as the beginning of a much awaited dry bulk recovery.
- Capesize rates have surged over the past couple months, and are now well above average industry breakevens.
- This has much to do with rising Chinese demand for iron ore and coal. But what’s behind this demand spike, and can it continue?
Overview:
Imports of iron ore and coal compose a significant portion of global dry bulk demand. In fact, two-thirds of dry bulk market demand comes from the transportation of iron ore and coal. China imports two-thirds of the world’s seaborne iron ore and its coal imports account for almost a quarter of the global coal trade.
Naturally, as Chinese demand shifts for these commodities, both commodity prices and dry bulk rates respond accordingly.
The dry bulk market is now hitting breakeven rates for Capesize vessels, which is the vessel of choice for transporting iron ore and coal into China. The report says, 93% of all cargo for Capesize bulkers is comprised of iron ore and coal. They note that “at present, most Capesize bulkers are being used for ore transportation between Australia and China, and Brazil and China.” Therefore, it might be time to examine what’s behind this move, with special attention to the iron ore market in China, in order to determine the sustainability of this environment.
Companies with exposure to dry bulk include Diana Shipping, Inc., DryShips, Eagle Bulk, Genco Shipping, Golden Ocean Group Ltd., Navios Maritime Holdings, Inc., Navios Maritime Partners L.P., Scorpio Bulkers, Safe Bulkers, Inc., Star Bulk Carriers Corp. and Ship Finance International Limited.
Background:
In my recent Dry Bulk Supply Side Update (August 2017) we noted an improving picture regarding vessel supply which looked set to provide some positive momentum to the market. This is indeed one reason for the improving environment, but not the only one.
But prior to this, back in May, I authored an article entitled Time To Shift Our Attention In DryBulk which explained how it was now time to turn our attention to the demand side of the equation.
This proved to be very true as it is now the demand side which appears to be responsible for much of the recent move in rates.
In Intermodal’s week 33 report they confirmed:“the upward trend in the Capesize segment is definitely being supported by the strong momentum in the key iron ore trade routes.”
Here we take a look at the iron ore market and consequently steel market in China where a significant amount of activity has created quite a shift.
Iron Ore Demand:
The root of the recent move in Capesize rates can be traced largely to increasing demand for iron ore in China.
This increasing demand for iron ore can in turn be traced to steel production, which consumes 98% of the iron ore imported into China.
In July, China, which accounts for half of global steel production, saw output climb 10.3%, twice as fast as in June, to another monthly record. Chinese companies are churning out more steel than ever to meet government-driven infrastructure demand. Additionally, the sub-index for activity growth in China’s construction sector grew to 62.5 in July 2017-the highest level for this metric since December 2013 reflecting a red-hot property market.
China’s real estate growth accounts for the majority of steel consumption in China followed by infrastructure builds.
Bloomberg reported:“The spur to demand from booming local factories and construction has pushed up Chinese steel prices and led to a sharp drop in exports. Overseas sales sank 32 percent in July from a year earlier, the lowest level for the month since 2013, according to customs data released on Tuesday.”
Activity in China’s steel industry expanded in August at the fastest pace since April 2016. The Purchasing Managers’ Index for the steel sector rose to 57.2 in August from 54.9 in July, data from the China Federation of Logistics & Purchasing showed.
Additionally, the Production Index rose to 61.7 from 58.1 in July, expanding for the seventh consecutive month, while the New Orders Index rose to 66.6 from 63.1 in July.
Margins:
Demand is strong as reflected in these numbers but another main driver for steel producers would be increasing profit margins.
The spread between steel prices and imports of iron ore (along with coking coal) help determine indicative operating conditions of steel mills, and raw materials demand.
Recently, Chinese steel prices surged to a more than four-year high.
The high price has led to some of the highest profit margins in several years for Chinese steel producers.
In fact, some mills are reporting margins breaking the 1,000 Yuan/ton range ($149/per ton).
The report says that this strong market has continued for several months with no sign of abating: “Chinese rebar steel futures rose nearly 2 per cent on Thursday and posted their fourth monthly gain in a row after data showed growth in the country’s manufacturing sector sped up in August, underpinning the outlook for steel demand.”
With the peak demand months of September and October approaching production should remain strong.
Imported 62% Fe:
With such high margins and the Chinese steel industry under greater scrutiny from the Chinese government amid a pollution crackdown, there is little incentive to use lower grade iron ore which currently composes quite a bit of domestic stockpiles. This has led to greater demand for higher quality iron ore imported from Brazil and Australia.
The Sydney Morning Herald quoted a trader in Jinan in China’s eastern Shandong province: “there isn’t a lot of high-grade around and Chinese mills are preferring high-grade because they want to produce more with steel prices rising.”
Evidence of mills’ changing preferences is showing up at China’s ports, where stockpiles of ore surged to record levels in June. But Rio has estimated it’s lower grades that accounted for 80 per cent of the increase in the holdings in the 12 months to July as steel producers snatch up higher quality iron ore leaving the low quality behind.
This raises a crucial point about port stocks and how current numbers may not reflect their actual ability to provide the desired supply for the steel sector. More imports may be in store as low grade stockpiles already in port are sidelined.
Again, reflecting the desirability of higher grade ore, the Government of Australia, in its latest quarterly resources outlook, noted that prices of 58 per cent ore were 27 per cent lower than 62 per cent in April to May, compared with an average of just 14 per cent since 2012.
A more recent report out of Bloomberg shows that spreads between 62% Fe and 58% Fe have exploded higher since 2016.
The report says that, “Iron ore has surged since mid-June as reforms in China have helped to sustain demand for steel at the same time that officials are tightening up on pollution curbs. All of that has stoked demand for higher-grade iron ore, which both causes less pollution and allows mills to maximize output, enabling them to take advantage of robust profit margins in the world’s largest producer.”
Steel Mills:
Since we are on the issue of quality, the closure of plants that inefficiently or illegally produce low quality steel could be another reason for higher iron ore imports. The report says that China has closed 727 steel plants representing a capacity drop of 120 million tons in the first half of the year.
Not only did these plants have less efficient operations but many were utilizing lower quality iron ore, much of which was domestically mined, either because it was cheaper or as they tried to remain under the radar of authorities.
These capacity cuts could be responsible for a tightening of supply, leading to increased prices, representing greater profit margins, resulting in an production increase, which would explain high utilization rates among more efficient steel operations.
Once again, these more efficient operations that produce higher quality steel begin by utilizing higher quality imported iron ore. Now couple this with better than expected demand from infrastructure and the property market, and we can begin to see why the seaborne iron ore market appears so strong.
Will It Last?
Going forward, supply is set to tighten further as more inefficient (or illegal) plants face closure. Of course, even the perception of a tightening supply could initiate a price increase. Recently the China Iron and Steel Industry Association said in a strong statement that the jump in steel futures was driven by speculation over the impact of coming capacity cuts, not fundamentals.
This casts a shadow over the sustainability of this recent move and they are not the only ones who doubt that this strong market will continue.
Bloomberg cited a couple sources that seem skeptical of the current market: “We see this as a bubble,” said Kirill Chuyko, a strategist at BCS Global Markets in Moscow. Aditya Mittal, chief financial officer of ArcelorMittal, said last month that steel margins have exceeded normal ranges and may fall back, “The number we’re seeing today has some risks,”.
With the China National Congress meeting in the beginning of the fourth quarter some have expressed concern that infrastructure demand may take a hit as policy makers rein in stimulus that’s left China overly reliant on government directed projects and manufacturing for growth. Some believe they may try to cool red-hot property and steel markets while shifting to a more consumer directed economy.
But there is also a argument to be made for the bull market continuing.
Seth Rosenfeld, an analyst at Jefferies International told Bloomberg: “While Chinese steel margins appear unsustainably high, mounting supply restrictions may prolong the current up cycle to the benefit of global steelmakers”. He commented further, “Chinese supply side reform, leading to lower exports at higher prices, has done far more to buoy global steel markets than Trump or any other Western politician could achieve.”
Richard Lu, an analyst at CRU consultancy based in Beijing stated in an interview with Reuters: “In anticipation of less supply of steel, there should be some traders and end-users bringing forward their purchase plan”. He continued, “Because of expectations of reduced supply, prices may rise further in coming months, so it’s better to buy now.”
The Business Insider, Australia, reported that Vivek Dhar, mining and energy commodities analyst at the Commonwealth Bank, says this expansion in margins will likely continue to support iron ore prices in the short-term.
“The recent surge in iron ore prices reflects restocking demand, a shortage of medium and high grade ores and last, but not least, high steel mill margins.” He added, “we continue to see the iron ore rally gaining momentum in the short run as Chinese steel mill margins continue to remain elevated.”
Conclusion:
As far as the seaborne iron ore market is concerned we have increasing Chinese steel production that is coming from higher quality mills with elevated utilization levels. These mills have a preference for higher quality iron ore, which is being reinforced by higher margins and a government crackdown on pollution.
This high quality iron ore is not readily available through domestic mining and a great deal of iron ore at the ports is lower grade.
In fact, Bloomberg reported that Deutsche Bank AG said in a May 19 report after analysts took a local tour that as much as 39 percent of port holdings are lower-grade material.
Rio Tinto recently pointed out that lower-quality products account for 29Mt (80%) of the 36Mt increase in port stocks over the last 12 months (to July 2017).
Dane Davis, an analyst at Barclays Plc. noted, “when steel demand is running hot, high volumes of stockpiles don’t matter, as they are lower-quality ores and not needed at the moment.”
Margins and demand would have to decrease significantly for this condition to change and frankly that might not be in the cards.
On the supply side that may be due to a significant amount of new supply coming online, including Vale’s S11D mine and Rio Tinto’s Silvergrass mine, which should keep iron ore prices under control thus maintaining healthy margins for steel producers if demand remains firm.
On the demand side, it seems unlikely that Chinese authorities would remove entirely an infrastructure based stimulus plan without a transitional phase. Aside from the steel industry there would be numerous other industries impacted as well as millions of Chinese workers dependent on these measures.
Additionally, a red-hot housing market might be tough to cool.
Macquarie Bank stated that they see a “lifting in investor sentiment towards Chinese demand, with the strong June macroeconomic prints – including the third-highest ever loans data – having presented a more robust picture of activity for the second half of 2017.” Consequently they see “the outlook for steel bullish for at least the next six to nine months.”
It’s also worth noting that stockpiles of rebar at Chinese traders stood at 3.88 million tons as of Aug. 25, still less than half of this year’s peak of 8.4 million tons reached in February. Which means a key signal for the end of the iron ore rally and steel bull markets may be preceded by the start of a new steel product inventory restocking cycle.
China Steel vice president Lee Shin-min told the Taipei Times that “customer inventory has remained low in China and restocking demand is likely to continue to stimulate steel prices in the fourth quarter.” This is one consideration behind China Steel Corp, the nation’s largest steelmaker, raising the prices of steel products for delivery in the fourth quarter by an average of 5.6 percent.
Even if Chinese domestic consumption of steel begins to wane let’s not forget that exports were down 32% in July, year over year. So China could look to the export market once again to account for weaker domestic demand and as a low cost producer should have little trouble recapturing market share, especially if global demand remains firm.
Regarding global demand, the report says: “Globally, a cyclical upturn in steel demand is anticipated backed by an ongoing recovery in the developed economies along with an accelerating growth momentum in the emerging and developing economies.”
Finally, there is even talk of a shortage materializing. In Intermodal’s week 33 report they reported that participants are said to be stepping up the stockpiling…fearing steel shortages in Q4 2017 and Q1 2018.
So, from where I’m sitting it appears there is quite a bit of room left for this bull to run.
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Image source: Bloomberg
Source: Seeking Alpha
