Iron ore, the “red dirt” that is the key ingredient for the manufacture of steel, is attracting significant interest again, both internationally and within China.
Its price has just seen one of its sharpest ever rallies, almost doubling in value over seven months to hit $126.35/mt on July 3, responding to a confluence of supply and demand-side factors.
While the price seems to have subsided in recent days, the intensity of the jump has surprised many, who say that the market has effectively disconnected from its fundamentals. A deeper look at the market's current key drivers may provide some answers.
At a macro level, there have been several factors impacting the supply of iron ore this year, most notably ongoing ramifications of reduced output from Brazil following the Vale dam disaster, coupled with residue impact from Cyclone Veronica hitting Australian production.
Against this backdrop, demand from Chinese steel manufacturers remains robust. While long-term term contracts are being fulfilled, the price of marginal iron ore traded on the spot physical markets has increased, reflecting tight supply and strong demand.
Bright spots on supply sideBuyers point to the fact that Brazil's Vale restarted operations at its Brucutu mine in late June, with the full resumption of wet processing after a drawn-out legal tussle, thereby reducing uncertainty over the longer-term supply of low-alumina iron ore.
"Since the Vale accident, our term contracted volumes have not seen any significant impact. There have been lower spot volumes in the market for products like BRBF, but there has not been any real concern with regards to our long-term supply," one large-sized Chinese steel maker said.
Additionally, the Australian supply chain is recovering, with spot supply volumes from Down Under showing signs of improving. Total iron ore shipments out of West Australia hit 22.1 million mt in the week of June 24 and BHP contributed a year-high of over 7.5 million mt. So why are prices still so elevated?
Despite this light at the end of the tunnel, certain supply constraints look set to remain. Vale has stated that it expects its sales volume guidance for FY 2019 to be at the midpoint of its earlier projection range of 307-332 million mt, which still marks a sizeable cut from loftier projections of 400 million mt before the accident.
”The Brucutu start will help the market but I don’t think it will be followed by a swift restart of Timbopeba and Alegria. We are expecting Vale to fall in the bottom range of their guidance,” Serafino Capoferri, a research analyst from Macquarie Group, told S&P Global Platts in an email last week.
"I think the worst is over in [terms] of physical tightness. But with Rio & BHP output down year on year, 60 million mt of capacity still offline in Brazil and feeble supply response from high cost producers, the market will stay tight and prices will likely average above the cost curve in the second half of 2019,” Capoferri said
“In short – I think iron ore is sticky near term, the market is not what it used to be," he added.
Aside from the current market expectations of tight spot supply from Australian miners in July and August, there are views about a residue impact from Cyclone Veronica earlier in the year.
"There were disruptions to mining operations and shipments following the cyclone, but a rather unsustainable ramp-up in production afterwards might have contributed to current issues faced in the form of worsening specifications for mainstream medium grade fines," one international trader said.
Rio Tinto adjusted its guidance on 2019 Pilbara shipments to 320-330 million mt, from 333-343 million mt, after experiencing mine operational challenges resulting in a higher proportion of lower grade products.
Spot availability was clearly dented by Veronica as well as the Brazil dam disaster, trade activity observed by S&P Global Platts shows. The number of Australian and Brazilian spot cargoes transacted during the second quarter of 2019 was 34% lower than in Q1 2019, and 30% lower than in Q2 2018.
China steelmaking drives demandMeanwhile on the demand side, steel output has been strong, and the signs are that this will continue at least until margins turn negative. Over January-June, China's pig iron and crude steel production increased by 7.9% and 9.9% year on year to 404.21 million mt and 492.17 million mt, annualizing at 808 million mt and 984 million mt, respectively.
In a bid to remove itself from the list of the 10 most air-polluted cities in China, Hebei province's Tangshan city will order 20-50% output cuts at sintering plants, blast furnaces and converters until the end of July. Otherwise, no steel mills have indicated that they plan to reduce production in response to the margin squeeze. As a result, China’s steel production is expected to stay high, which could provide some support to iron ore prices.
While unseen in recent years, the kind of volatility from recent weeks will be familiar to iron and steel industry veterans, who know that this simple "red dirt" can indeed be prone to significant price moves.
The leap this year followed a lengthy period of stability, with prices mostly oscillating between $50-80/mt as far back as late 2014. During this period, supply kept pace with rising demand from Chinese steel mills, as their profit margins improved on the back of China's steelmaking capacity cuts.
But between 2008 and 2014, the market saw a series of wild moves, starting during the global financial crisis, when prices fell from $170/mt to $55/mt in just three months. Prices didn’t stay low for long, yo-yoing back to $186/mt in just over a year in April 2009.
Thereafter, the market saw sharp swings in either direction until the start of 2014, when strong supply and a slow decline in steel prices started to act as a drag on iron ore.
”Previous price swings were more driven by strong demand moves, generally China led. This one is more supply driven following the Vale outages. The one thing that is similar is that, given how steep the iron ore cost curve is, prices tend to have to move a long way, either up or down, to invoke a suitable supply reaction,” according to Colin Hamilton, an analyst at BMO Capital Markets.
As the old saying goes, the best cure for high prices is high prices. These should eventually incentivize additional supply, which will eventually translate into lower prices. As so often in commodity markets, the key question is when.