Getting bullish on China again and iron ore

I feel like a broken record (anyone remember those – before we had tapes, CDs and now iTunes and MP3?) with all this bullish data. Just repeating the basics on the most important markets and yet it seems that commentators are still coming up with reasons to be bearish and the build up of cash just continues.

The term deposits peaked out a couple of years ago at just over A$540bn but bank savings bank accounts keeping rising and are now the larger component of deposits (building societies and credit unions seem to have been reasonably static for some years). Is this saying that some of the professional investors have shifted into equities and property but households generally are still negative? Maybe we haven’t seen the lows in interest rates yet here in Australia? What interest rate is needed to get more of this cash moving?

Well while we are wondering Australia’s take on fear and greed, the rest of the world is getting along with life and the global economy seems to be expanding nicely. I do like this SWIFT `Nowcast’ Index of transaction flows. Tells you a lot about how the whole world is working. This is for OECD.

OECD is quietly picking up activity and the US is getting better. On global economic matters, however, China is always the topic of discussion and so many non-residents seem to have a wonderful ability to prognosticate quite unsuccessfully on the impending demise of China’s economy.

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Source:World Bank

The growth rate is slowing. It has been for many years but in 2013 it added US$570bn to GDP and in 2014 this should be US$620bn to take total GDP to US$8,850bn. 2014’s US$620bn is more than twice the US$ amount for 2009. Some economic slowdown!

And if it isn’t China’s economic growth rate being a big enough talking point then the next focus issues have to be the impending iron ore price collapse and the demise of the steel industry in China.

Lots of talk and talking heads who think that `Fed policies’ will determine the iron ore price. Just like commentators a generation before who knew the Fed` policies’ would control the oil price. Certainly didn’t work there. People, we have already had peak conventional oil production 6-7 years ago.

So let’s look at the steel industry in China and then we will look at iron ore and then look at what it may be saying about China generally. Some very interesting stuff so stay with us here.

First and foremost the steel industry in China is probably the biggest development in any Australian miner’s career, experience or lifetime. Global steel production in the 1980s and 1990s was a quaint business that grew at 0.5-1.0% pa (or not!) at about 780-800mtpa. The issues of the day were overcapacity in Europe, new technologies (continuous casting, thin slab casting and new coatings on flat steel products that were revolutionizing building products) and the failure of the Japanese steel industry to get above 110mtpa out the newly installed 140mtpa capacity. Two mtpa new capacity in Rep of Korea was a major industry talking point and the whinges of miners with new underutilised mining capacity were unheard on deaf ears.

So for China with February’s new record annualised output of 809.5mtpa you just have to watch with jaw on the ground. In the past decade China has increased output by more than 50mtpa in a year seven times and 90% of it all comes from blast furnaces. The US produces around 88mtpa and Japan is doing 107mtpa. You should really forget about India. It is still only 80mtpa and about 65% is EAF.

Production in China is around 800mtpa and the 2011-2015 5 Year Plan had a 6%pa growth rate that will probably be well exceeded. So expectations of 1,000mtpa are probably still on track.

China has had a strong growth in domestic consumption of steel that has gone primarily into infrastructure and commercial investment such that annual apparent per capita steel consumption of 508kg is above that of the US 323kg (but below Japan 544kg an well below Rep of Korea 1159kg). This is concerning some people.

However, China has produced about 4,000mt of crude steel over the past decade. If it is assumed that ALL of this was utilised domestically it would be 3.1t/capita which is less than 30% of Japan and Korea and about 50% of the OECD average. And of course crude steel is just that and net steel products would be 5-10% less and some must have been exported so the above numbers are conservative. And that is before considering export of finished products like ships or cars.

Steel demand has been for construction and about 60% of output is long products of H-beams, rail, re-bar and wire. Much new capacity is flat and rolled products for consumer durables (vehicles and white goods) where growth is strong and should be maintained. Flat products have moved from about 30% to 40% of output over the past decade.

Steel demand should therefore be maintained at about 1,000mtpa or increase for at least another decade. The dynamics of the current 1,000mt steel capacity in China show major new large scale capacity at the ports and decline in the smaller mills inland.

The new large mills take ~90% imported feed so need more imports as inventory. These take hematite and not magnetite and produce more flat and rolled sheet products which is where the growth is (motor vehicles, white goods etc).

The old mills produce mainly rod and bar (for rebar and H beams for construction) for local and regional provincial markets and make it from mostly local magnetite ore. What has also happened in recent times is that the demand for rebar has been so strong (has maintained a 23% output share for a decade) that the govt has been unable to close these regional mills that supply the low specification rebar steels into local markets and which are so polluting.

The establishment of these new steel mills on the coast has resulted in iron ore imports in Dec Qtr 2013 running at a record of >900mtpa rate.

It is important to understand this in the context of the recent build up in port stocks in China.

Figures of 105mt for 40 ports data today (many tiny ports included here, some only 300kt so not true market stocks) compares with 100mt for 20 ports in late 2012 (about 90mt today) when imports were only about 650mtpa. On 20 ports data it was 100mt/650mtpa = 56 days) in late 2012.

Today, on 900mtpa imports, 20 ports inventory gives just 36 days of inventory. This is why every Australia iron ore producer is selling all output and Gina Rinehart can bring another 55mtpa of capacity on line. So at 900mtpa and rising, 90mt (20 ports data not the Bloomberg 40 ports stuff) is just over a month compared with 40-45% higher eighteen months ago.

The influence of the Chinese New Year Spring Festival is yet to be understood in the iron ore and steel industries but the annualised monthly steel production pattern in the diagram above clearly shows this seasonal event. The combination with Christmas when the Spring Festival comes early seems to have a disproportionate impact. So inventory issues come with steel production and also iron ore. Steel mills run down inventory at this time and this certainly happened in 2013-14.

This period I consider has much to do with the current iron ore price. The decline down to US$104 was possibly the low for this part of the cycle and the sharp jump back to US$110 suggests the market is in reality still very tight. Port inventories could decline sharply as mills rebuild theirs.

The other side of this graphic is that probably 60% of China’s magnetite concentrate capacity is losing cash. Almost Chinese iron ore production is magnetite concentrate.

330mtpa of Chinese magnetite ore that on average costs about US$125/t (ore grade is <20% Fe and falling so needs about 6 tonnes to make a tonne of 68% Fe magnetite concentrate.) and some are small underground mines as well.

83% of this output is from small to medium mines and only 17% is from large mines.

This is the marginal tonne of iron ore. High cost producers! Iron ore price has no relationship to Australia costs of production!

We should expect to see as much as 150mt of local magnetite ore production from these small mines shut down and see an increase of hematite iron ore imports.

But don’t beat up China over magnetite. The world has used more magnetite than hematite over the past 50 years. It has only been the rise of the high quality Pilbara 63% hematite plus the Brazillian 62% iron ores that fed into Japan that got hematite running.

Magnetite (67-72% Fe) is exothermic, is denser, purer and is really the preferred input into most US and European blast furnaces. Almost all Chinese old capacity has had magnetite feed.

Much of the older steel mills have been constructed around Chinese iron ore mines which are almost entirely magnetite mines producing a 68-69% Fe product.

Magnetite ore requires crushing and grinding of 4-6 tonnes of ore to produce one tonne of concentrate. This is costly and requires large amounts of electric power that is a direct and externally invoiced cash cost.

China uses almost 1.2bn tonnes of iron ore pa and produces about 330mtpa ( ~25%) of this production is uneconomic in cash terms at US$130/t.

The iron ore market may have a surplus in 2014 of about 30mt (have we had it already?) but will be in balance in 2015 and 2016. India’s ban on iron ore exports has helped keep the market tight as well.

I still expect higher iron ore prices this year! And new highs in the next couple of years.

Coming back to the steel industry itself, China does have a massive and principally chaotic steel industry that has seen a dramatic increase in steel making capacity that has significant nameplate over-capacity. Almost all (~90%) is blast furnace pig iron from primary iron ore and very little is Electric Arc Furnace (EAF) from scrap(<10%).

Much is new larger size plants that will allow closure of many small plants but the product mix is different with small plants being mostly long products (for H-beams, rod and low spec rebar etc) and the new being sheet, plate and higher quality H beam and rail.

The small regional mills are ideal for local rebar supply and are difficult to close given that demand has been strong.

Most old mines and older steel mills are away from the coast. New mega mills are being located on the coast and are being designed for hematite and will require imported iron ores, not local expensive magnetite concentrates.

Australian miners recognise this and have built capacity to meet the current import demand and future import demand that will grow faster than pig iron production. Imports over the past decade have had a 20%pa Compound Average Growth Rate and are now about 77% of demand.

BHP, RIO and FMG have increased capacity and expect to complete programmes to add additional capacity over the next few years.

These capacity expansions have been at the request of customers who are seeking more ore.

The reports from the iron ore companies have generally more accurate than the views of analysts in North America over the past few years as shown by record iron ore exports and a good iron ore price!

Australian Iron Ore Exports

 

So the kick in crude steel production in China in February is very interesting and could have an impact on port inventories and iron ore prices. The next month will be very interesting!

Also interesting is the kick in steel being matched by action in the Shanghai stock market.

The Shanghai market jumped 2.72% on Friday 21 March and followed up yesterday with a further 0.91% on the 24th! Short term this looks intriguing.

Medium term this looks very intriguing!

 

And long term this just looks excitingly bullish!

With the stock market in India powering on to all-time highs, downtrend breaks by Japan and Taiwan and with Rep Korea and Hong Kong ready to shoot higher it seems to me we will be having an Asian Boom very soon!

And with commodities ticking up again everywhere, you guessed it, an Australian Resources Boom!

And to go back to the start of this note, with A$1568bn of Australian bank deposits to fuel it! That is before the foreign investors come in.

To whet your appetite for what is ahead, just look at the graphite stocks mentioned over the past several months. LMB up 1500% and VXL (+1:1 VXLO) up 270%.

I can think of similar numbers for stocks in gold, copper, technology metals, Cooper Basin, unconventional oil and gas, lead and zinc, tin, the many varieties of iron ore, coal and uranium over the next year or so. And many more will come out in things novel and innovative in resources and, of course, mineral discoveries. Remember them?

Barry Dawes

BSc F AusIMM(CP) MSAA MSEG

Hong Kong

25 March 2014

Follow me on Twitter @DawesPoints

Disclaimer: I own LMB and VXL/VXLO.

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