As noted earlier, while European stocks and US equity markets have ignored the commodity crash in China, which in addition to iron ore plunging limit down, also saw rubber tumble 7% lower, and steel rebar, coke, coking coal plunge over 6% ...
... Axiom's Gordon Johnson warns (as we did a month ago) that the worst is yet to come, and in fact, the "backdrop of near-record/record iron ore inventories and aggressive domestic and seaborne iron ore supply, paints a nightmarish picture for iron ore prices over the coming months."
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Here are the choice excerpts from his overnight note "Why We Feel Iron Ore Prices Are Slated For a Sharp N-Term Fall (Even From Here) & Why Iron Ore Stocks (FMG; RIO; CLF; X) Are Attractive Shorts Right Now"
SUMMING THE BELOW ANALYSIS UP: With China’s April PMIs disappointing, suggesting China’s tightening measures are beginning to take hold (i.e., demand for steel in China is now weakening), we expect steel supply in China to begin to moderate imminently; stated differently, this suggests iron ore demand is in the process of waning, which, against a backdrop of near-record/record iron ore inventories and aggressive domestic and seaborne iron ore supply, paints a nightmarish picture for iron ore prices over the coming months. On this trend, we would be adding to shorts in FMG, CLF, RIO, and X.
SO WHY THE IRON ORE PRICE PESSIMISM & CONFIDENCE ON THE FMG, RIO, CLF, and X SHORTS?: We believe, when looking at the data, iron ore prices are on the precipice of a “spectacular decline”. As detailed below, iron ore imports into China were up 11.4% y/y to 95.6mt in March, and YTD were up 12.2% y/y to 271mt. In our view, due to what is expected to be a 1%-2%% fall in y/y crude steel production in China in 2017, which is below the +1.04% y/y growth seen in 2016, we believe elevated imports through March point to continued inventory build, as well as a lack of seaborne-supply-discipline to falling iron ore prices (iron ore prices fell 11.9% through March).
Exhibit 1: Despite Waning Crude Steel Output in China, Import
Growth Y/Y is Strong than Ever
Source: General Customs Administration, Axiom Capital Research.
Furthermore, moving to the domestic production of iron ore in China this year, it’s clear that momentum is picking up in a very rapid manner (a troubling trend if you’re an iron ore bull). That is, of the 266 domestic Chinese iron ore mines Mysteel tracks, capacity utilization has risen from 62% as of mid-April 2016, to 69.5% as of mid-April 2017; stated differently, domestic iron ore production is up 21.4% y/y to 45.6mt YTD. This stellar growth, we believe, is a byproduct of higher prices driven, we believe, not by fundamentals, but rather the “financialization” of the futures trading market in bulk commodity materials in China (where traders have to constantly speculate, in the overnight markets, on the daily directional shifts in commodity prices – due to the duration mismatch in assets vs. liabilities in the ~$4tn off-balance-sheet Wealth Management Products market). Yet, with the cash cost of iron ore production in China at ~$57.8/mt, until prices fall below this level, we would expect the “rising tide” of supply to continue to be a headache for the iron ore bulls.
Exhibit 2: Domestic China Iron Ore Supply is Growing Sharply Despite
Record Inventories and Record Seaborne Imports
Source: Mysteel.net, Axiom Capital Research.
WHAT ABOUT INVENTORIES? In addition to the above, as can be seen in Exhibits 3-4 below, inventories at both the Chinese ports and steel mills are at/near record highs. That is, looking first to major Chinese ports’ iron ore inventories, we note that inventory has increased by 15% thus far this year, and is 33% higher than at the same time last year; in fact, there is enough iron ore inventory sitting at the ports in China to construct 13,000 of Eiffel towers (that’s a hell of a lot of iron ore). Furthermore, while they have come down off their peaks experienced this year, steel mills’ iron ore inventories in China are also still high when compared to historical levels. Yet, despite these high inventory levels, iron ore prices remain above our $40/mt target for April; in short, we believe this dynamic is a byproduct of both: (a) stellar margins for steel mills earlier this year, pushing them to prefer higher-grade iron ore in the face of higher coking coal prices, and (b) the aforementioned preference for higher-grade iron ore, in the face of bloated coking coal prices, enabling elevated production rates at Chinese steel mills. However, based on the sharp fall in Chinese steel mill profitability (discussed below), we believe both of these dynamics have come to an abrupt end (a problem if you are an iron ore bull).
Exhibit 3: Chinese Ports’ Iron Ore Inventory is Sitting Near
Source: Shanghai Steelhome, Steel Business Briefing, Axiom Capital Research.
Exhibit 4: While Off Their Highs, Days of Imported Iron Ore Inventory
at China’s Steel Mills Remain High on a Relative Basis
Source: Mysteel.net, Axiom Capital Research.
AND SPREADS? Moving on to price trends, we note that steel prices in China have been in sharp correction territory for some time now; and, with Cyclone Debbie in Australia pushing coking coal prices higher, steel mill profit margins have deteriorated. This, in turn, caused a shift in approach from the steel mills in China. More specifically, instead of opting for the higher-grade version of iron ore, in an effort to shift costs lower, mills in China instead moved toward the lower-end version of iron ore (due to its ready supply at both the ports, and at the domestic mills in China) – this trend, which remains intact today (and is an outsized, yet underappreciated, in our view, risk to seaborne iron ore prices), is evidenced by the sharp fall in the premium of 62% Fe grade iron ore when compared to 58% Fe grade iron ore (see Exhibit 6).
Exhibit 5: China’s Blast Furnaces’ Cash Margins Have Come Down
Considerably From the Highs
Source: Bloomberg, Axiom Capital Research.
Exhibit 6: High-Grade Iron Ore Premium is in Full
Source: Metal Bulletin, Beijing CUSTEEL E-commerce Co., Axiom Capital Research.
CONCLUSION: With the above as a backdrop, as we have warned for some time now, the recent correction in steel prices in China should come as no surprise. Why? Well, as detailed below (Exhibit 7), with China continuing to pump out record levels of crude steel output (i.e., supply), despite an aggressive push by the PBoC to clamp down on property speculation, as well as elevated interbank lending rates (suggesting liquidity has tightened) – Exhibit 8 – it seems, currently, supply is outstripping demand (a recipe for disaster for prices). Furthermore, as detailed below in Exhibit 9, given expectations of steel demand coming into 2017 in China were elevated (on expectations of a Trump-driven rally, as well as reflation in China), aggressive inventory building defined the better part of C1Q17 in China. Consequently, with China’s April PMIs disappointing, suggesting China’s tightening measures are beginning to take hold (i.e., demand for steel in China is now weakening), we expect steel supply in China to begin to moderate imminently; stated differently, this suggests iron ore demand is in the process of waning, which, against a backdrop of near-record/record iron ore inventories and aggressive domestic and seaborne iron ore output, paints a nightmarish picture for prices over the coming months. On this, we would be adding to shorts in FMG, CLF, RIO, and X.
Exhibit 7: CISA Members' Daily Crude Steel Output
Source: China Iron & Steel Association (CISA), Axiom Capital Research.
Exhibit 8: Interbank Lending Rates in China Have Moved Structurally
Higher… Suggesting PBoC Tightening is “On the Menu”