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Will China's induction furnace steel whac-a-mole finally come to an end?

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Will China's induction furnace steel whac-a-mole finally come to an end?

China's central government has set the elimination of induction furnace-based steel by June 30 as the cornerstone of its supply-side structural reforms of the industry this year.

Earlier measures against induction steel have failed to deliver results. But now, the official narrative surrounding them has taken a decidedly strident turn.

Induction furnaces are the next low-hanging fruit, after wins in 2016 were clinched through the removal of over 80 million mt/year of capacity, of which about 30 million mt/year had not been in production.

Will 2017 finally see the end of China's induction furnaces? S&P Global Platts outlines some key facts and recent policy articulations.

Tough talk on induction furnace boosts steel, iron ore prices

What is induction furnace steel?

Induction furnace steel, called ditiaogang -- literally ground bar steel -- in Chinese, is made by melting scrap in induction furnaces, according to the definition employed by China's central government since 2002.

The process doesn't allow effective control over the composition and quality of the steel produced, and is hence criticized for posing a hidden danger when passed off as quality steel.

Such furnaces use induction heat to melt scrap, and are classified into three groups according to their operating frequencies: line frequency (50-60 Hz), medium frequency (150-10,000 Hz) and high frequency (above 10,000 Hz).

According to the China Iron & Steel Association, line and medium frequency furnaces are the most used in steelmaking and are also the target of policies aimed at eliminating induction furnaces.

Billet produced this way is sometimes rolled into long products like rebar and wire rod. A segment of induction furnaces focus on stainless steel production.

ALSO READ: Timeline: China's crackdown on induction furnace steel

How much induction furnace steel is out there?

With most induction furnaces operating illegitimately, official capacity figures do n0t exist, and estimates have ranged between 80 million and 120 million mt/year.

Production last year was pegged at 30 million-50 million mt, and while that would make up 3.7-6.2% of China's crude steel output of 808.37 million mt, the actual proportion would be smaller, as market participants have said induction furnace steel is not counted in output data by the National Bureau of Statistics.

How do induction furnaces operate?

Induction furnaces have been a thorn in the eye of Chinese steel industrial policy since 2002, but have largely been successful in evading measures. Operators have been astute in expanding furnace inner volumes, adding secondary processing units and branching out into casting and rolling in order to stay ahead of closure thresholds.

Often, however, those added facilities are merely a facade for inspectors and are not put into operation, according to the CISA. Induction furnace operators tend not to issue invoices for their purchases and sales and their full-time staff members are few and transient, which means they avoid costly social security contributions borne by legitimate steelmakers.

The more underground, home-brew operations play a cat-and-mouse game with the authorities. They simply dismantle facilities quickly before inspections, and assemble them again after, market participants said. They allegedly affix forged labels on their steel to pass them off as products from reputable steelmakers, and distribute material locally so that they are difficult to detect, the sources added.

What's the market impact of induction steel?

The slew of measures targeting induction steel has had an uplifting effect on the price of steel and raw materials. This follows the logic that the closure of induction furnaces would shrink the overall supply of steel, especially long products.

Further, given that the steel demand that had been met by induction furnaces should now be fulfilled by integrated steelmakers, iron ore demand should rise. Scrap supply should also increase as a result of less demand from the induction furnaces, which may lead to a decline in its prices.

Chinese steel prices have climbed steadily since the start of this year, after the CISA chairman articulated the central government's goal of eradicating induction furnaces by June 30.

Long products have been the main gainers, with rebar in Beijing having jumped 32% to Yuan 3,940/mt ex-stock, and billet in Tangshan rallying 20% to Yuan 3,310/mt ex-stock as of February 27, Platts data showed. Wire rod and hot rolled coil have risen 14% and 4% respectively.

As margins widen to Yuan 200-300/mt for longs producers and Yuan 500-600/mt for flat steelmakers -- also thanks to the retreat of metallurgical coal prices -- Chinese mills have said they have ramped up capacity utilization and boosted hot metal productivity by buying higher-grade iron ore, in turn supporting iron ore prices.

Skeptics who see the steel price surge as heady exuberance say the volume of steel to be removed by the induction furnace purge will be too limited to have a significant impact, and that the market has had its nose led by speculation in the futures market. They have also pointed to moderate steel demand and growing stock levels.

The market's bullish streak may continue in the coming months, as construction activity in China resumes in the spring. Strong domestic prices have also meant that less Chinese steel has been exported as overseas markets have not been able and willing to match these prices. This has, in turn, reopened doors for Turkish rebar into Southeast Asia, something not seen since 2011.

Besides rebar, Turkish wire rod as well as HRC from India and Russia have also made headway into Southeast Asia amid high Chinese offers.

Chinese steel exports in 2016 slipped 3% from the previous year's record high to 109 million mt, with volumes tapering in the second half of the year.

The key to whether the induction furnace crackdown will ultimately translate into a further fall in exports this year is whether Chinese demand remains strong enough to sustain domestic steel prices.

-- With analysis by Zhang Jing

This was first published in the March 2 edition of SBB Daily Briefing.