The impact of unsustainable production in Chinese Steel-making plants, to avoid the inevitable employment consequences, has created a 'glut'. This excess inventory will need to be worked through before spot Iron Ore (and Coking Coal) prices can stabilize.
Morgan Stanley believes the sharp raw material price declines since mid-July followed a collapse in Chinese steel prices and aggressive margin compression. This was the result of continued weakness in demand and the over-production of crude steel, reflected in rising producer inventories. This is in turn has resulted in aggressive thrifting of raw material purchases. More recently, the price declines have accelerated with Chinese re-bar and HRC prices reaching 33-month lows.
In their view, prices of steel making raw materials can recover in 4Q 2012 and in 2013, but spot prices for both iron ore and coking coal first have to fall below the marginal cost of seaborne (not Chinese) production to drive out the short-term supply overhang. In addition, Chinese steel mills have to complete finished product and raw material de-stocking to stabilize both steel and raw material prices (if they are ever allowed to). Iron Ore prices could fall 17% further before this 'stabilization' and spot coking coal over 8% from current levels.
Spot Iron Ore and metallurgical coal prices...
Where will prices stabilize?
Our best estimate of where spot prices for iron ore and hard coking coal might bottom-out in this environment is one in which prices reflect levels that are below the marginal cash cost of the true seaborne market, not sellers of distressed or displaced cargoes in this environment, the price has to reflect a level that drives the seaborne sellers out of the market, albeit temporarily. At the same time, as the spreads between domestic and international prices widen (especially in the iron ore market), prices at levels below true seaborne marginal cost should also become sufficiently attractive to beleaguered Chinese mills to finally entice them back to the market, albeit on a small scale until steel prices stabilize. At the time of writing, with spot prices for 62% Fe fines CFR into North China at US$99.40/dmt, Australian net back prices on the IODEX platform for a capesize cargo, with an 8.03% moisture adjustment, are US$94.32/t, while Brazilian net backs are at US$82.60/t with a 9.0% moisture adjustment.
The global seaborne iron ore cost curve (ex-China), 2012
Worst case scenario – prices could overshoot below the seaborne marginal costs of around US$92/t DMT CFR. We think the true seaborne market (which excludes China domestic production) is driving current prices. Given that there could be as much 4Mt of displaced cargoes trying to find immediate buyers in this environment, we believe there is a possibility prices could overshoot on the downside.
Based on data from CRU Consultants, we estimate that on a business or cash equivalent basis, the 90th percentile of seaborne suppliers (ex-China) as a proxy for marginal cost is US$79/t on a FOB wet metric tonnes basis for two small Australian producers. At current spot freight rates and an average moisture content of 8%, this equates to an implied CFR price of US$92/t, some 7.7% below the current spot.
To highlight the very short-term risk of prices overshooting even below this level, we have assumed a potential further downside risk of 10% below this indicated price level, suggesting a possible floor in the price around US$82-83/t cfr North China for 62% Fe fines. At this level, prices would have fallen to the 86th percentile of current true seaborne costs, a level 16.9% below the current spot price.
Interestingly, at today’s spot price, the 4Q 2012 midpoint price is at US$93.25/dmt CFR DMT North China, slightly above the estimated level of the seaborne marginal cost. On the same basis of a potential overshoot 10% below estimated seaborne marginal cost, spot hard coking coal prices could fall as low as US$150-155/t fob North Queensland, indicating further potential downside of 5.2-8.3%.
Source: Morgan Stanley