Steel Markets Irrational Behaviour

Research Note From RBS Morgan

 

Subject:	Steel markets irrational behaviour
Analyst:	James Wilson

 

Todays sharp price drops in the likes of RIO, BHP, FMG and AGO are likely because of recent data out of China suggesting that steel prices have plummeted late last week. We understand that some of the steel being sold into the market was at “Fire sale prices” according to reports we’re getting. The short term demand macro for steel appears fragile off the back of European weakness and seems to focus on the 100Mt stockpile of ore in Chinese ports (which is normal lately).

Steel Traders noted that sales have been irrational and there’s expectation that prices are unlikely to stabilise until the market is restored to reason. This could bounce in days potentially, but at the moment the mood is negative and this is being reflected in the weakness of the major iron ore players this week.

As far as we are aware, structural long term demand appears in tact. In the short term volatility will remain on the back of irrational behaviour in China’s steel market.

Some points to consider:

The Good:

• Iron ore prices at $125/t (currently) is what we assume is the base price for the commodity since the majority of Chinese production costs ~$120-170 per tonne. Any drop below this figure just hurts domestic Chinese production. This is likely to result in a large proportion of China’s iron ore production running at little or no profit.
• China’s consumption is fed from ~50% internal domestic ores and 50% external ores sourced mainly from Australia and Brazil. We remain more competitive in price than just about every other global iron ore player due to our short shipping time to Brazil.
• Iron ore stockpiles at 100Mt represents around ~8 weeks of consumption (this is normal), this could reduce rapidly if mills decide to drawdown stockpiles rather than purchasing in the spot market. The China stockpiles have been sitting at 90-100Mt for the last 6 months so we don’t see an issue with this.  
• Capex commitment – BHP has committed to ~$9bn worth of iron ore expansion in the next 2 years (excluding outer harbour developments). RIO is forging ahead with it’s 353Mtpa expansion. FMG continues to develop it’s 155Mtpa expansion. Their data feeds are likely pretty good considering the size of investment so the long term strategy for these companies remains solid.
• Steel mills usually opt for lower Fe grade ores in these markets, it’s cheaper and its got better margins than higher grade ores. This is especially beneficial to AGO and FMG ore types.

The Bad:

• Mills may shut down for planned and unplanned maintenance whilst prices are volatile (and low). This may curb demand in the short term.

 

• We could see iron ore prices drop further as stockpiles are soaked up.
• Rapidly falling steel prices have dented the confidence of traders buying into the market. Traders are likely to sit on the sidelines until they see how far prices fall.  
• Brazil’s Vale is likely to push additional cargoes to the China market (usually deferrals out of Europe), having reported strong increases in production recently. Vale’s tactic is to usually sell into the China spot market, which could keep prices low for the short term.