A slump in China’s real estate, auto, rail and household appliance markets, coupled with a flailing Eurozone has led to very soft global demand for steel. All the while, global miners Rio Tinto, Vale and BHP have continued to ramp up production, which may mean a short-term glut in ore supply until demand catches back up. Traders will likely respond to the news by shorting global miners in the short term, but going long in 2020 when developing economies and the Eurozone recover. Expect more industry consolidation as smaller ore providers fail to weather the storm.
Mayan Predictions for Iron Ore
BHP’s stock has fallen 24% this year. Rio Tinto is down 33%. Investors are nervous for good reason; China – the world’s leading producer of steel – is loosing steam. 2012 is going to be a very bad year for iron ore.
China is able to supply 40% of its iron ore needs with domestic reserves, but the rest needs to be imported. In importing the other 60%, China consumes about half of the traded world supply of iron ore each year. This colossal demand for red earth allows the country to generate about 46% of the world supply of crude steel - approx. 700 million tons for 2011. About half of this output is pumped directly into the construction of domestic infrastructure.
With the Eurozone in a tailspin and the US a sneeze away from sickness, the world is importing less Chinese steel. As a result, China will have to swallow unprecedented volumes of its own products with fixed asset investment in order to maintain growth necessary for China to stay above 8% GDP growth. China needs to see strong growth in the major downstream industries of construction, autos, rail, durable goods and machine tools if it stands a chance of offsetting losses from exports to plunging western peers.
Q4 data has revealed a downturn in China’s real estate market. Sales and prices have taken a plunge, resulting in halted construction projects and a significant drop in land auctions to real estate developers. A drop in land sales has meant a natural decrease in new construction projects and a subsequent decrease in steel demand from this sector.
The government’s goal is to have 10 million units of government assisted housing under construction by the end of 2011. Some analysts say that the investment coming from this project will offset the slump in demand from floundering commercialized properties. However, a significant portion of the steel used in these projects will come from China’s 14 million ton stockpile of excess steel. Indeed, soaking up this excess was one of the factors that motivated the creation of this policy in the first place. If we assume that each unit of government assisted housing is 50 square meters, and each square meter consumes 50 kilograms of reinforcing steel bars, then the 10 million units set to begin construction this year will generate a demand for 25 million tons of raw steel materials. If 14 million tons come from China’s excess stock, then there will only be new demand of 11 million tons, or less than 1.6% of the country’s annual production capacity.
When you run the numbers, you find that for every 1% decrease in the construction of China’s infrastructure, the global demand for internationally traded iron ore drops by about 0.7%. Of course, apartments that aren’t built don’t need to be furnished with ovens and refrigerators, and so softened investment in fixed assets today will translate to weakened demand for steel to build household appliances tomorrow. Less apartment buildings also means a weakened appetite for Japanese and South Korea specialty steel. China imports roughly 6% and 7% of these countries total crude steel output, respectively. The immediate impact of a 1% slowdown may only be -0.7%, but the long-term impacts are far more severe.
If less steel is going into housing, and less steel will be required for durable consumer goods, then that leaves autos and rail pick up the slack. According to the CISA, between 50 and 60% of the weight of a typical car is made up of steel and a further 12 to 15% comprises cast iron. In the years following the financial crisis, the Chinese government spurred industrial growth with a series of policies stimulating the purchase of autos. Sales reached a climax in January 2010, seeing numbers as extreme as 124% growth month-over-month. Consumers, knowing that the tax breaks were set to expire, made their 2011-2012 purchases in 2010. Once the party ended, the hangover set in; October is historically a strong month for the industry, but sales YoY sales were negative this year for the first time, ever. China’s auto industry is in a slump, and will not need new steel production capacities any time soon.
Rail isn’t doing any better. A high-speed rail crash on July 23 followed by a number of accidents and industry scandals have caused the government to halt the construction of a number of new rail lines pending thorough investigations. Not only does this mean a greatly diminished demand for steel from the rail industry, but it also means that China is no closer to solving the problem of massive coal shortages caused by transportation bottlenecks. Already, 60% of all freight movements in China are solely for the transportation of coal. Many of China’s steel mills have had to relocate to the eastern seaboard to circumvent the rail issue and import its anthracitic coal directly from Australia. Wage rates are significantly higher in these areas, though, and coal prices are destined to see a seasonal spike over the winter, as China is still 68% dependent on coal for energy. These factors will spell a very hard year for a steel sector already struggling with profit margins of less than 3%.
Rock and a Hard Place
Government policies will finish what waning downstream demand has started. According to the most recent rounds of government policies, the goals for the steel industry is to destock, consolidate and upgrade. The Ministry of Environmental Protection and the Ministry of Industry and Information Technology have launched new stringent requirements for the reduction of pollutant emissions and energy consumption. China’s steel industry will have to eliminate many outdated production capacities, and invest a large sum of capital to renovate and upgrade.
At the same time that demand is declining, the industry will be ousting outmoded production capacities to meet China’s New Environmental Production Standards. This process will eventually restructure the industry to create a small number of massive players capable of churning out large volumes of a high-tech product mix. In the short term, though, industry output will be stagnant for at least the next year, meaning that there will definitely be no increase in China’s demand for iron ore any time soon.
Bullish Plans for a Bearish Decade
The CISA has forecasted that the growth of China’s demand for steel will slow to just 2.6% YoY by 2015, down from this year’s 4.6% YoY growth. November data showed a crude steel output of just 49.88 million tons – the lowest production in 14 months. Aussie giants Rio Tinto and BHP have responded to this news with the counterintuitive approach of ballooning their mining operations. Rio’s board has just approved a USD 14 billion budget for 2012 mining projects, up from this year’s budget of USD 12 billion. BHP is looking at similar expansion plans, and has earmarked more than USD 80 billion to invest in major projects and exploration by 2015. Sam Walsh, director of Rio Tinto’s iron ore division has stated that the mining industry goal is to increase iron ore supply by 100 million tons per year until 2020.
With supply ballooning and demand waning, prices have naturally taken a massive tumble. Iron ore spot prices fell 24% from early September to mid-December. A recent report from Reuters has stated that the plunge of spot market prices for iron ore and lukewarm tenders have indicated that the spot market is likely to drop further throughout the month. Steel mills, expecting additional price drops, are hesitating to purchase ore. As a result, stock of imported iron ore at Chinese ports have been hovering around 100 million tons, up from the usual volume of 70 million tons. Of course, this hesitation has become a self-fulfilling prophecy, and prices have continued to drop throughout December.
China Spot Index (CSI) for Iron Ore
Blue: Spot Prices for Imported Iron Ore with 62% Iron Ore Content
Red: General Index for Imported Powdered Ore
This dynamic will be awful for iron ore providers in the short term, but may have an eventual payoff. The “global miners” Rio Tinto, Vale and BHP Billiton are effectively an oligopoly that account for nearly 70% of the global trade of iron ore. China has a total of 77 large- and middle-sized steel mills that in 2010 posted net profits of RMB 89.7 billion. By contrast, 2010 profits for the three global miners more than tripled this figure.
The result of all of this money is that these giants are able to weather any storm. In flooding a waning market with a glut of commodities, these companies stand to take heavy losses. Indeed, recent reports show that BHP’s stock has fallen 24% this year. Rio Tinto is down 33%. However, the long-term benefit of this strategy is easy to see – the flood of ore into the market will strangle out smaller competitors. When the red dust settles in 2020, these companies will loom larger than ever with massive capacities to feed a rebounding India and a mature, technologically advanced China.
"If I have seen a little further it is by standing on the shoulders of Giants."
- Isaac Newton
Chris Lowder is the Director of Marketing Services at China Monitor. For more insights from China Monitor and the China Economic Information Network (中国经济信息网), please visit our website at www.chinamonitorisg.com
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