The iron ore equation: Do structural supply gaps and China policy stimulus = US$200/t?
Link copied to
Iron ore has already confounded most analysts’ expectations by trading above $US200/tonne. The next question for investors is — can it stay there?
To analyse the broader market, Stockhead caught up this week with Magnetite Mines (ASX:MGT) director Mark Eames, who provided some historical context on the supply/demand dynamics fuelling current prices.
Recent headlines for iron ore prices have largely centred around the demand side — largely China’s appetite for steel inputs as part of its post-COVID infrastructure push (more on that later).
But to explain current prices, markets are also assessing that demand-side strength in the context of ongoing supply constraints.
On that front, Eames said it’s useful to look backwards at the last China-led mining boom, which ran from around 2005 to 2015.
“Those were fairly buoyant years for iron ore. Prices ranged between about US$120 and US$160 for most of that time, and stayed there for a whole decade,” he said.
In response, a number of global iron ore majors ramped up production efforts.
Those investment outlays ran well into the tens of billions, and were accompanied by outbound capital flows from China itself (which was looking to vertically integrate its steel supply chains).
“It was a staggering amount of money. In my experience in mining there’s never been anything like it,” Eames said.
“So right across the board there was a massive wave of investment in iron ore, and not all of it was spent well,” he added.
But the net result for iron ore markets is that “this wave of supply hit the market”. And prices recalibrated:
“Between 2015 and 2017 prices ended up falling to around US$40/t, and stayed down at around US$60-US$80/t until quite recently,” Eames noted.
Going back even just a year ago, the analyst consensus was for prices to average around US$60/t.
“Conventional wisdom said it was all going lead to prices staying low,” Eames said.
Recall that iron ore majors got burnt by the 2015 supply glut, which left them hesitant to pull the trigger on further investment.
But conventional wisdom underestimated China’s appetite for steel.
So from a position of oversupply, the sector has now been “caught short”, Eames says.
“In fact what’s happened is fairly simple — China increased steel output by 32 per cent, and increased iron ore imports by a bit less than that.”
This time, the pick-up in demand wasn’t met by multi-billion dollar supply projects. Which means iron ore prices only had one way to go — vertical:
Dalian iron ore resembling a crypto pump…
— David Scutt (@Scutty) May 10, 2021
For Eames, the supply glut turned into a supply shortfall, which has been about six years in the making.
“If you add up production — from BHP to Rio Tinto, Fortescue and Vale — since 2015 they basically haven’t expanded at all. And in my view they won’t be able to do so at any significant level for years to come,” he said.
“I’ve worked for most of the majors in my career — they’re all flat out and can’t get another tonne out of their ports.”
“The reason I know that is prices are trading above $US200/t, so if they could they would.”
Factoring in the structural supply imbalance, another key question relates to Chinese steel demand. Specifically, how long it can be maintained.
In his research note yesterday, CBA analyst Vivek Dhar reiterated that China’s COVID-19 policy response has flowed through to strong support for local steel producers.
Despite elevated iron ore prices, “steel mill margins are currently at the highest level since 2018”, Dhar said.
Assessing the Chinese demand outlook, one gauge Dhar often refers to is the special bond quota for local governments.
“Local government special bonds have become the primary financing tools to support public led infrastructure projects,” Dhar said.
Quotas budgeted for 2021 have dipped from last year, but only slightly — to CNY3.65 trillion (from CNY3.75tn in 2020).
And in recent historical context, “the 2021 quota is still much higher than the 2019 quota of CNY2.15tn”, Dhar said.
S will $US200/t iron ore become the norm?
“The answer is no one really knows in my view,” Eames says. “But what I do know is there’s no significant new supply coming onto the market.”
“There’s just no iron ore out there, and if there was it would be on the market already. So it will take a fair bit of time for there to be a supply response.”