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China's shift to high-grade iron ore structural not cyclical, experts say

The consensus among analysts at a major iron ore conference in Perth this week was that Chinese steel mills' preference for higher-grade ore and continuing discounts for lower grades is a structural shift, not cyclical, which will favor the "big four."

Citigroup Asia commodities strategist Tracy Liao told attendees at the Global Iron Ore & Steel Forecast Conference in Perth March 21 that the company expects 58% and 62% grade differentials to stay wide for longer.

The company has this belief because mills' margins globally are set to stay higher for longer thanks to Chinese efforts in rationalizing supply, and the fact that "we're not going to see a major acceleration of investment in steel yet."

With China's environmental rules in place, the country's mills can expect higher costs on emission controls and will be incentivized to use better quality ores.

Citi believes the 58% fines are experiencing a discount of over US$20 per tonne, and will "stay high for a while."

BHP Billiton Group iron ore asset president Edgar Basto said the structural improvement in China's steel capacity utilization rate and profitability, coupled with more consistent environmental regulations, had led to a shift in the preference of seaborne iron ore as mills seek out higher quality raw materials, while lessening their interest in lower-quality product.

"The market consensus expects a trend of 62% iron seaborne supply as producers in Brazil ramp up as 58% discounts continue to deviate from historical levels; however, we believe our mines produce some of the best quality ore in the Pilbara ore, which ensures we are in a position as a low-cost, high-grade iron ore producer to meet demand," he said.

Perth-based Wood Mackenzie senior analyst for mining and metals fundamentals Kim Christie said not all producers were better off despite the 62% iron ore benchmark price averaging US$71 per tonne in 2017, well above the 58% average in 2016.

"Suppliers of high grade ore and pellets continued to experience strong margins, but low grade suppliers, especially those in Australia, are seeing margins contract to around 10%," Christie observed.

She said Fortescue Metals Group Ltd. was the lowest-cost iron ore supplier to China before taking into account product quality, but when the costs are adjusted to take into account its 58% product, it became the highest-cost producer of the four majors.

Similarly, Vale SA is the highest-cost producer of the four majors, but its costs fall in line with Rio Tinto and BHP when product quality is taken into account.

Penalties have also risen for alumina and silica discounts, which have more than doubled since the middle of 2017.

With ongoing consolidation in the Chinese steel industry and steel margins looking sustainable in the short term, Wood Mackenzie expects grade-driven price diversions to continue in the "foreseeable future," Christie said.

However, iron ore producers are responding to the challenge and are moving quickly.

Christie noted that Vale's S11D project was ramping up and taking advantage of high-grade premium by producing record tonnages and tweaking mine plans to maximize ore quality.

She said that if Anglo American PLC advances its Minas Rio project it will balance out some of the pellet market, and Vale is also planning on increasing pellet output with two plants restarting toward the end of this year, including Tubarao.

Vale also said in February that Sao Luis was on track to also restart by the end of the current quarter.

In placing major projects in the context of the impacts of grade differentials, Christie also noted that FMG's Eliwana project would be higher grade than the Firetail mine in the Solomon Hub, and BHP is replacing Yandi with the higher-grade South Flank.

"We expect the two-tier market to stay, but to what extent is still uncertain, but China's changing steel market will ensure that the larger discount will be the norm for lower-grade ore than we have traditionally seen in the past," Christie said.