Rally in Prices Not Ironclad
Temporary tightness should abate as demand falters and supply surges.
Iron ore prices have surged and leveraged mining stocks have more than doubled since February. We think this rally is unsustainable, as it is based on short-lived demand measures and near-term supply disruptions. As temporary tightness in the market abates, iron ore prices should fall to $30 per tonne in the long term, driven by falling Chinese steel demand and rising scrap availability. We believe iron ore and metallurgical coal miners are overvalued, with the shares of Anglo American (NGLOY), CSN (SID), Fortescue (FMG), Teck Resources (TCK), and Vale (VALE) now trading at more than 2 times our respective fair value estimates. BHP Billiton (BHP) and Rio Tinto (RIO) also appear overvalued.
Demand Stimulus, Supply Disruptions Have Driven Rally in Iron Ore Prices
We believe that a combination of Chinese demand stimulus and supply disruptions has driven iron ore prices from their low of $37 per tonne in December to as high as $69 recently. This rally brings prices back to figures not seen since the beginning of 2015, when cost curve levels were higher. Since then, cost-cutting and producer currency depreciation have shifted the curve downward. We believe this rally will prove fleeting as the drivers that brought about this rally give way to faltering Chinese demand and expansion of low-cost supply.
Iron Ore Prices, 62% Fe Delivered to China ($/Tonne)
Demand Stimulus Through State-Owned Enterprises Is Unsustainable
Faced with faltering growth, the Chinese government has reopened the old stimulus playbook. Fixed-asset investment, or FAI, growth accelerated to 10.7% in the first quarter, up from 8.9% in the fourth quarter of 2015.
The FAI recovery has a narrow foundation. Investment by state-owned enterprises accounted for all of the improvement. SOE FAI growth surged from 9.1% in the fourth quarter of 2015 to 23.3% in the first quarter of 2016. Meanwhile, private FAI continued to decelerate, slowing from 9.2% to 5.7% in the first quarter. Private FAI is roughly twice the size of SOE FAI.
The FAI recovery is likely to prove unsustainable. China's SOEs and local governments are largely responsible for the excess capacity that besets China's economy and the bad debt that continues to build up on bank balance sheets. As a result, while the stimulus was successful in driving stronger FAI and a stabilization in GDP growth, credit expanded at roughly twice the rate of GDP in the first quarter. We estimate China's total debt/GDP breached 300%, more than twice what it had been in 2007 and 3 times the levels typical of most emerging economies.
SOEs Have Accounted for All of the Improvement in FAI
The FAI recovery has driven iron ore demand higher than anticipated. Following 13 months of year-on-year declines, Chinese steel production leveled off through March. Domestic iron ore supply struggled to keep pace, declining 8% in the first two months of the year.
Monthly Chinese Steel Production Growth, Year on Year
Higher Steel Prices Drive Greater Steel Production and Iron Ore Demand
Another possible explanation for the rally is that the turnaround in FAI and recovery in steel demand caught China's steel producers off guard. Heading into 2016, inventories of cold-rolled and hot-rolled steel were 15% and 16% lower, respectively, than they had been a year ago. Not only were inventories low, but steel production hasn't kept pace with demand growth. As a result, producers continue to draw down inventories. As of April 15, cold-rolled and hot-rolled inventories were 20% and 33% below prior-year levels. Rising Chinese steel prices, up by more than 60% since December, have encouraged even greater steel production, as they allow previously uncompetitive steel mills to become profitable. The expectation of greater steel production suggests higher iron ore demand.
While government stimulus can help support construction activities in the short term, we believe China is running out of rope to continue this debt-fueled growth. We expect construction activity in the country to wane as the pace of urbanization slows. This should drive steel demand from 700 million tonnes in 2015 to 630 million tonnes by 2025.
Chinese Hot-Rolled Coil Prices (CNY/Tonne)
Steel Production Has Also Been Pulled Forward by Efforts to Limit Pollution
Steelmakers have restocked following Lunar New Year closures, and steelmakers in the top-producing province have pulled forward production in anticipation of closures later this year. Steel mills in Tangshan, part of Hebei province, which accounts for 37% of China’s production, raised production after being told that they would need to shut down from late April to October during an international horticultural exhibition. The scramble to churn out volume before closures pulled forward steel production, driving short-term demand for iron ore and met coal demand.
It is now evident that the authorities will only target air pollution limits, with minor impact on steel production. As such, it is unlikely that the rapid surge in steel production will continue. Furthermore, a growing share of China’s steel production should go toward exports, which should displace steel production in other countries. We also expect the composition of Chinese steel production will be as important a driver as the size of steel production. Rising scrap availability in the country will push EAF share of production from 6% currently to 11% by 2025. A much larger wave of scrap will arrive when structures built near the peak of the cycle reach end of life; this trend should displace demand for iron ore and met coal.
Supply Disruptions Will Be Short Term in Nature
as Long-Term Production Targets Remain Intact
On the supply front, disruptions in production have led to temporary tightness in the market. Large iron ore miners have trimmed their 2016 production targets. As a result of maintenance on its Pilbara rail network, BHP Billiton lowered this year's Western Australia production guidance to 260 million tonnes from 270 million tonnes. Issues with the rollout of its automated rail system led Rio Tinto to cut its production guidance this year to 330 million-340 million tonnes from its previous target of 350 million tonnes. Rio Tinto maintains guidance to ship 350 million tonnes of iron ore in 2016; however, the lower production guidance suggests downside risk if inventory drawdowns can’t plug the gap. Cyclone Stan, which ripped through the region in late January, also affected operations at both miners. The first quarter of the calendar year is usually the weakest, being cyclone season.
Following the dam failure at Samarco, the 30 million-tonne operation remains off line, a further (potentially short-term) strain on supply. Samarco's management says it intends to restart operations this year, albeit below full capacity. While we await confirmation from Brazilian authorities before including this volume in our models, the restart would help ease the current market tightness.
BHP and Samarco Production (Million Tonnes)
We expect these issues to be temporary. Both BHP and Rio Tinto remain solidly profitable on a cash cost basis and will aim to maximize production within their existing infrastructure systems. While it may be delayed, we remain confident that BHP will ramp up output to its long-term target of 290 million tonnes and Rio Tinto will reach its targeted 360 million tonnes, including its Canada-based production. Hancock Prospecting's 55 million-tonne Roy Hill mine will be a major addition, with the bulk of its capacity likely to ramp up in 2016.
David Wang, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.