China’s virtual lockdown due to the coronavirus outbreak in February resulted in soaring steel inventories, which depressed prices and margins. Iron ore has been resilient, but for how much longer? Paul Bartholomew and Sebastian Lewis discuss the impact of the virus and when markets may return to normal.
Supply demand imbalance leads to rising inventories
The impact of the coronavirus on the economy was revealed by China’s two manufacturing purchasing managers’ indices with both falling to record lows in February. The PMI published by China’s National Bureau of Statistics dropped to 35.7 points in February from 50 in January, while Caixin’s PMI, which is more weighted towards small, private industry, fell to 40.3 down from 51.1 in January.
This means the February PMIs were weaker than during the global financial crisis of 2008 – no real surprise as factories struggled to return to normal operations and many shops remained closed. The China Passenger Car Association said domestic sales slumped by 92% on year in the first half of February, noting there was “barely anybody at car dealers as most people stayed at home.”
Manufacturing activity has resumed more quickly than construction, but factories have struggled to boost capacity utilization rates due to interrupted supply chains. Based on a recent S&P Global Platts survey of 26 companies active in the Chinese steel sector, we estimated that less than 30% of migrant workers had returned to their workplace in the final week of February.
Pent-up demand should result in a boost to flat steel sales as activity recovers. Futures and physical markets rallied in the March 2-6 week on expectations of stimulus, but the government has indicated that it will not be resorting to stimulating the property sector to boost growth. Instead, it will channel funding towards infrastructure. The focus will be on projects that have already been approved. Comparing investment on a like by like regional basis, total investment approved this year is down 3% on year.
On the supply side, the biggest factor is rising inventories of finished steel and other metals-related products. In the March 2-6 week rebar inventories were up by 160,000 mt on the week before. In some cases, mills and traders have run out of space to store steel.
Steel overflowing at a warehouse in Chongqing, China, March 2020. Click to enlarge.
Logistical constraints are also hampering deliveries, though the situation is gradually improving. Chinese mills kept output steady during Lunar New Year and were initially unable to conduct maintenance work on facilities – often resulting in a de facto production cut – due to a lack of workers and equipment.
Mills in some parts of the country have since deepened production cuts due to high inventories and tight cash flow. Others have restarted or ramped up production as logistics and demand have improved. Platts estimates 3 million mt less pig iron will be produced in March, compared with a 4.5 million mt loss in February. There are signs of life getting back to normal in China but we do not expect steel demand from construction and infrastructure to improve markedly before the end of April.
Iron ore’s remarkable resilienceAt the time of writing seaborne iron ore prices were still around $90/mt CFR China – way above analyst expectations of $80/mt for this year. It could be argued that iron ore is overvalued at such levels given the lack of downstream demand and muted steel production, but supply has been tight in the first quarter due to wet weather and cyclones in Brazil and Australia.
Total iron ore exports from Rio Tinto, BHP, Vale, Fortescue Metals Group and Roy Hill of 20.42 million mt in the first week of March were down almost 9% on the year before, according to Platts cFlow vessel tracking tool. Supply will start to recover later this month, and with demand subdued and steel inventories at elevated levels, iron ore prices are likely to come under pressure over the next few weeks.
Home market will drive steel price recoveryDomestic steel prices have been weighed down by a lack of downstream demand, though positive market sentiment regarding expected infrastructure investment stopped prices from falling further.
Domestic hot-rolled coil prices averaged Yuan 3,527.5/mt ($508/mt) in February, down from Yuan 3,877/mt in January. February was the weakest monthly average since June 2017, Platts price data shows. As it did during the 2008 financial crisis, China’s recovery will be largely a domestically-driven one.
Asian competitors Japan and South Korea – both impacted by the coronavirus – have lowered their steel prices to sell more into the export market. This means China will find it harder to significantly lift exports in coming months, having suffered a 27% on-year drop in January-February. Rebar demand should start to pick up as construction activity ramps back up to normal levels by the end of March. Steel hot rolled coil (HRC) prices were supported by low inventories before Lunar New year, but that is no longer the case now.
Steel mill margins have been squeezed by high iron ore prices and falling steel prices: HRC margins slumped from $70/mt in January to $22/mt in February, while rebar margins dropped to $33.33/mt in February from $60.49/mt in January. Iron ore prices should ease as supply tightness eases, but steel stocks will need to be drawn down considerably before margins improve.