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Chinese credit gap concern key to raw material consumption, expert says

S&P Global Market Intelligence analysis presented at a major iron ore conference March 22 revealed that China faces increased competition for liquidity, so closing its credit gap needs to be a priority amid mid-grade ore price concerns, while Citi is more bullish for high-grade producers.

China is transitioning from an engine of world steel production growth to a steady state with limited year-over-year growth, with a 0.6% rise in crude steel output expected this year, S&P Global Market Intelligence senior commodity analyst Max Court told the Global Iron Ore & Steel Forecast Conference in Perth, Australia.

"China's iron and steelmaking industries are experiencing difficulties as competition increases to determine industry champions," he told delegates.

Supply-side reform is being encouraged more by government policies than by the industry's current economics, and Court said these conflicting interests would need to be carefully managed by market players over the near term.

"We believe that short-term price expectations for mid-grade iron ore remain skewed to the downside," Court said.

"We see prices declining this year to an annual average of US$66 per dry metric tonne cost and freight [CFR], and will continue to decline to an annual average price of around US$64/dmt CFR by 2020.

"We continue to expect large-scale volatility as premiums on higher-grade iron ore products are contested and environmental trends, trade tensions and interest rates continue to add uncertainty to the global iron ore market."

This follows near-term concerns expressed the previous day by Rio Tinto's supply chain and services managing director, Ivan Vella, though he said the company was more comfortable with iron ore's prospects in the medium to longer term.

Citigroup Asia commodities strategist Tracy Liao told delegates March 21 the group does not believe that the continued build-up of port inventories will lead to a decline in iron ore prices because the composition of those inventories is a lot more important than the total levels.

"Around 33% high-grade fines among all port inventories will be important for iron ore pricing, and most of the inventories sitting at ports are low grade, so they're not directly relevant to headline iron ore prices," she said.

"But we think the low grade as a percentage of total inventories will stay high because of the structural shift to high-grade iron ore by mills."

There is also the concentration of high-grade pellets, which Citigroup believes are preferred by mills, as Chinese government-mandated cuts will incentivize mills to shift to consuming more premium products.

"Incrementally, if we continue to see the high-grade slack of the total port inventories coming off, it means the total iron ore market itself looks good, at least the high-grade part, while the low-grade is oversupplied so they may consider cutting production," Liao said.

Credit gap concern

Court emphasized that China's credit gap would need to be closed in a "gradual" way to maintain steady consumption of raw materials, particularly with the increased competition for liquidity as quantitative easing is unwound and the global credit environment starts to tighten.

While China is making progress in restructuring its steel industry by cutting crude steelmaking capacity, Court noted its industry remains relatively fragmented; the country's top five steelmakers accounted for just 18% of its steel output in 2016.

Yet as BHP Billiton Group's iron ore asset president, Edgar Basto, also pointed out the previous day, China's Belt and Road initiative infused some longer-term optimism.

China's infrastructure sector demands about 24% of its steel, which will need significant investment in raw material consumption, and Court said that factor was an "incremental" driver for raw material demand this year and beyond, along with the Belt and Road Initiative.

He added that the disparity across Chinese provinces in terms of economic development and GDP per capita was a concern for the country and presented a challenge for the demand environment.

As was often noted at the conference, the clampdown on steel mills in China's northern provinces continues, yet rebar margins remain healthy at about US$117/tonne as of March 20.

China's growing focus on environmental efficiency is improving steelmakers' capacity utilization, yet production of iron ore run-of-mine fell by just 52 million tonnes year over year in 2017.

Court said in an interview on the sidelines of the conference that steel margins are still staying "pretty strong," so Chinese mills have plenty of choices when it comes to what material they're putting into their blast furnaces.

"Given the environmental edicts from Beijing are being hammered down, there's no wriggle room to start avoiding that and putting in lower-grade material into the blast furnace," he said.