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Stock Strategist Industry Reports

Rise of the Scrap Age

We're cutting our iron ore and met coal price forecasts as the long-term demand outlook weakens.

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Beaten-down iron ore and metallurgical coal prices have prompted investors to wonder whether we've finally reached a bottom. The recent recovery in iron ore to $50 per tonne from $40 in December might suggest as much. Consensus, while damped from years past, also sees better days ahead. The average sell-side forecast tracked by Metal Bulletin has iron ore ascending to over $60 in five years. This optimism is predicated on the notion that loss-making mines globally and within China will close, pushing prices higher. The story is similar for metallurgical coal.

While conditions ought to improve on the supply side, we are increasingly concerned about the demand side, especially in China. Our updated outlook for Chinese steel demand and steel scrap availability suggests the market hasn't yet seen the worst for iron ore and metallurgical coal. Based on a sector-by-sector steel use forecast, we now expect Chinese steel demand to fall to 648 million tonnes by 2025 from the peak of 765 million tonnes in 2013. Our previous forecast was for a shallower decline. Meanwhile, as China's steel stock in use reaches its end of life over the coming decade, we expect domestic scrap availability to rise 10% annually. Electric arc furnace production should grow too, to 11% of steel production by 2025 from 6% in 2015.

The implications for iron ore and metallurgical coal prices are grim. We expect iron ore prices will fall to $35 per tonne (constant dollars) over the next five years, declining to $30 in the long run (versus $55 previously). We expect real met coal prices of $80 per tonne through 2020, declining to $75 in a midcycle environment (versus $110 previously). For the companies we cover, changes in our fair value estimates depend on exposure, operating leverage, and financial leverage. The impact of lower prices is partly offset by greater cost-cutting, reflective of the cost curve underlying our updated forecast.

A scrap age looms on the horizon, with Chinese electric arc furnace substitution set to accelerate in the decades to come. In terms of steel production methods, we expect China to follow the path of the United States, as both are large countries endowed with vast domestic iron ore and met coal resources. As the steel stock reached end of life in the U.S. during the previous century, the country generated increasing quantities of scrap available for use in electric arc furnaces. Electric arc furnace production tracked steel scrap availability closely, growing from nothing to 30% of total steel production in just 20 years even as blast furnace production more than doubled. This suggests that scrap availability is the critical long-term driver for this production method. The bulk of China's steel production currently comes from blast furnaces due to the lack of steel available for recycling, a byproduct of the country's young steel stock. However, the rapid buildup of steel stock in China over the past decade means a significant amount of scrap will become available in the future. Scrap will weigh on iron ore and met coal demand, as electric arc furnace production doesn't require the use of these feedstocks. Over the next decade, we expect machinery, transportation, and other products reaching end of life will drive more than a doubling of China's scrap availability, displacing 55 million tonnes of Chinese iron ore demand and 31 million tonnes of met coal demand by 2025. This trend will subsequently accelerate as an influx from the recycling of long-lived construction structures, such as buildings, starts to make its way into circulation.

While we've long been bearish on Chinese steel demand, we think it's likely we weren't bearish enough. Our previous work, based on a top-down look at Chinese steel use intensity, suggested demand would decline from a peak of 765 million tonnes in 2013 to 688 million tonnes in 2016 before recovering to 708 million tonnes by 2020. Our new bottom-up forecast, which we believe better captures much of the sector-by-sector nuance not found in a top-down model, suggests a decline to roughly 650 million tonnes by the end of the decade. We expect construction-related demand, approximately 60% of the total, to decline a cumulative 31% through 2025 as the pace of urbanization slows and excess real estate supply is absorbed. Machinery demand (20% of total steel use) will continue to grow, albeit at a far slower rate than China registered during prior years. Transportation-related steel consumption (10%) will also be a partial offset as Chinese passenger vehicle demand rises to meet developed-country levels. Consumer durables demand (10%) should grow but decelerate as ownership levels are now far higher than they had been. Still, the decline in construction overwhelms growth in the smaller segments.

Even with our updated forecast for weaker steel demand, China's steel stock per capita will remain an outlier versus peers at similar stages of economic development. In other words, there is still further downside from our forecast if China quickly reverts to steel stock levels more commensurate with its income. A faster normalization of steel stock levels in China would portend even weaker demand and thus lower iron ore and met coal prices than we forecast.

In an effort to survive the downturn, miners have slashed costs at astounding rates. Cost-cutting efforts have been supported by exporter currency depreciation and lower oil prices. For example, over the past year, Fortescue has nearly halved its break-even cost--all-in cash costs including capital expenditures but excluding interest expenses--to $32 per tonne from $63 per tonne. Anglo has cut its met coal cash costs by $27 per tonne. While these actions have helped sustain profits amid lower prices, they come at the expense of flattening the cost curve. This in turn has led to a material decline in the marginal cost of production and further pricing pressure. While some may point to supply discipline as a reason to be more bullish, we would argue that it is unlikely. There remains considerable supply still to come on line, with the big three miners and Roy Hill continuing with their growth projects. Furthermore, high-cost players tend to implement drastic cost cuts amid declining prices and thus continue producing at much lower prices than expected.

David Wang, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.