Understanding Iron Ore Price Drivers in 2018

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1 Understanding Iron Ore Price Drivers in 2018 By Annie Gilroy Jan 29, :31 PM Can Iron Ore Prices Improve in 2018? Iron ore price movements in 2017 The volatility in iron ore prices in 2017 has continued into 2018 as well. Iron ore prices reached a peak of $95 per ton in February 2017 and tested a low of $53 per ton in July The wild price movements mainly had to do with China s appetite for the raw material as domestic steel prices fluctuated along with demand starts on a weaker note Prices in 2018 have fallen ~4% to $74 per ton. The most recent bout of weakness is due to weak physical demand in China due to seasonal factors. Steel mills are curbing output to adjust to the weak demand. Price differentials and miners The price drop is evident across all the grades of iron ore (XME). According to the Metal Bulletin, on January 26, 2018, benchmark iron ore prices (62% content) fell 0.85% to $74.4 ton while 58% content fines dropped 2% to $41 per ton. The iron ore with a higher content of 65% fell by a

2 smaller 0.8%, settling at $90.1 per ton. Investors should note that after C hina s switch from lower-grade ore to higher-grade ore, the differential between sub-benchmark and abovebenchmark grades has expanded greatly. In fact, one of the reasons Cleveland-Cliffs (CLF) cited in its recently released 4Q17 results for accelerating the closure of its Australian mining operations is the increased discount for its subbenchmark iron ore. BHP (BHP) Rio Tinto (RIO), and Vale SA (VALE), on the other hand, on average produce benchmark or higher-grade ore. In this series, we ll explore the potential course iron ore prices could take. We ll also look at the forward-looking and coincident indicators for iron ore. What Record Iron Ore Shipments from Port Hedland Mean for Prices Iron ore shipments The data for shipments for iron ore from two key destinations, Australia and Brazil (EWZ), are an important supply-side factor to watch out for. Since these two countries contribute to the majority of the high-grade seaborne iron ore supply, it makes sense to keep a tab on shipments from these destinations. According to the latest data released by the P ilbara P orts Authority, on January 9, iron ore shipments from P ort Hedland for December 2017 reached a record high of million tons, which also implies growth of 5.1% year-over-year (or YoY) and 11.7% sequentially. Shipments from Port Hedland in 2017 totaled million tons, growth of 5% YoY.

3 P ort Hedland is Australia s largest iron ore loading port. This port is used by three miners BHP (BHP), Hancock P rospecting, and Fortescue Metals Group (FSUGY). Rio Tinto (RIO), on the other hand, uses P ort Dampier. Shipments from Brazil While the exports from Port Hedland hit a record high in December, volumes shipped from Brazil fell in December by 6.7% YoY to million tons. In 2017, shipments rose 2.6% to million tons. Exports of iron ore from Brazil have been increasing yearly since China is the main destination for the bulk of Brazil s iron ore exports, forming 54% of the total exports in More supply going forward Apart from monthly irregularities, iron ore exports from Australia and Brazil have been on the rise. Many miners in these countries are still ramping up. Roy Hill in Australia and Vale SA (VALE) in Brazil are still in their ramp-up phases. This ramping up should lead to additional volumes in the coming one to two years. Iron Ore Port Inventories Hit a New High, Prices Reel China s iron ore inventory Inventories at C hina s ports reflect the balance between demand and supply. The ore that isn t used up by steel mills typically piles up at ports. Rising inventories lead to the conclusion that demand in the country is weak, and vice versa. Because this indicator helps provide a sense of the direction of iron ore prices, it s important to keep track of it.

4 Inventories hit a record-high again Iron ore port inventories have remained high almost throughout Despite this performance, iron ore prices picked up their pace toward the end of the year. The most-cited reason for this anomaly was the stockpiling of lower-grade iron ore imports, as C hinese mills switched from lowergrade ore to higher-grade ore in a bid to control pollution. Still, higher inventories tend to pressure prices. In 2017, inventories hit a record many times. According to the latest data from SteelHome, inventories have hit another record high of million tons. This high implies growth of 30% year-over-year (or YoY) in inventories. According to ANZ, this growth implies approximately 50 days of imports. Analysts have started worrying that iron ore stockpiles that are enough to produce 107 million cars could pose a threat to prices. Record stocks have already started pressuring prices. The most active May delivery contract on the Dalian Commodity Exchange fell 4.8% on January 23. According to the Chinese Iron and Steel Association (or C ISA), iron ore supplies continue to rise with port stocks testing record highs. With oversupply continuing, there s no foundation for iron ore prices to sustain gains. Effect on iron ore prices If the selling pressure on iron ore prices persists, miners (GNR) producing iron ore such as Rio Tinto (RIO), Vale (VALE), and BHP (BHP)(BBL) could also come under pressure. C leveland- C liffs s (C LF) Asia-P acific division and Fortescue Metals Group (FSUGY) produce relatively lowgrade iron ore. These miners could come under increased pressure due to higher discounts. China s 2017 Iron Ore Imports Hit Record High: How s 2018

5 Looking? Customs data and China s iron ore imports C hina consumes more than 70% of the seaborne-traded iron ore. Therefore, to gauge the direction for future iron ore prices, it s important to look at Chinese iron ore imports. China s imports C hina s iron ore imports have remained very strong almost throughout In December 2017, imports fell 11% year-over-year (or YoY) to 84.3 million tons. For 2017 as a whole, imports showed growth of 5% to billion tons. This growth also represented a record-high imports figure for the country. Firstly, strong domestic steel prices have encouraged mills to produce more. Secondly, the switch to quality iron ore to curb pollution has increased the appetite for imported ore versus the domestic one. Strong iron ore import demand Capacity cuts in China are leading to higher steel prices. Steel mills have probably restocked in anticipation of higher demand as capacity cuts end in March. Most market participants believe pent-up demand should emerge after March, which should be conducive to iron ore prices. Even now, miners (XME) producing high-grade ore such as BHP (BHP), Rio Tinto (RIO), and Vale (VALE) are paid a premium over other miners. Miners such as C leveland-c liffs (C LF) and Fortescue Metals Group (FSUGY) could keep attracting discounts.

6 Can China s Steel Production Support Iron Ore Prices in 2018? China s steel production C hina s steel production in 2017 was strong overall. P roduction volumes were supported by strong demand and higher steel prices. C hinese mills have been taking advantage of higher margins to produce as much as they can. China s crackdown and the steel outlook C rude steel production in December 2017 was million tons, 0.3% lower year-over-year (or YoY). Due to steel production capacity cuts to curb pollution in the winter, production has somewhat seen a negative fallout. Overall in 2017, C hina s steel production was 4.4% higher than Production cuts are in place until the middle of March They could mean that production will see further weakness at least until then. Impact on mining companies The impact of lower steel production on iron ore is expected to be two-way. In the near-term, iron ore prices might come under pressure due to low demand. However, in the medium term, when the curbs are lifted, the pent-up demand from Chinese steel mills is expected to benefit these prices. Due to the switch from low-grade to high-grade material, high-content producers (P IC K) of iron ore can take heart due to premiums. Vale (VALE), BHP (BHP), and Rio Tinto (RIO) are the major iron ore producers mining high-quality iron ore. C leveland-c liffs (C LF), on the other hand,

7 produces sub-62% material, attracting discounts. Do China's Steel Prices Have More Room to Benefit Iron Ore Prices? China s steel prices We discussed, in the previous part of this series, how C hinese steel mills have increased their production in 2017 to take advantage of higher steel prices. C hinese steel prices have improved ~30% in Steel prices have more than doubled since their lows of late In this part of our series, we ll discuss how steel prices have performed in recent months. We ll also see what it could mean for its future outlook. More room to run? As steel demand remained firm and capacity cuts came into place, C hinese steel prices surged even more. According to Reuters, steel prices in China hit a nine-year high in the first week of December 2017 as the government s efforts to fight pollution in winter months continued. It added that this was true amid tighter supplies and unexpectedly healthy demand, especially in the east and southern China. According to the managing director of Japan s biggest producer of recycled steel, steep prices in C hina have more room to run due to C hina government s crackdown on steel capacity and synchronized global growth. He mentioned that hot-rolled coil prices in C hina could even approach $800 per ton in 2018, which is approximately 25% higher than the current prices. China s biggest steel mill, Baoshan Iron & Steel Co., mentioned that they expect their net profits to double when it reports its 2017 results.

8 Impact on mining companies While there s a possibility of a correction in the short term, the restocking activity after winter s cuts are expected to keep supporting steel prices as well as iron ore prices. This trend could be positive for seaborne suppliers (PICK) such as Rio Tinto (RIO), BHP (BHP)(BBL), Vale (VALE), and C leveland-c liffs (C LF). Iron Ore: China's Property Market Shows Signs of Weakness China property sector It s vital for iron ore investors to track movements in the Chinese real estate market (TAO). This sector constitutes more than 50% of the total steel consumed in the country. In this article, we ll discuss the C hinese property market indicators to gauge their outlook. Real estate investment growth In 2017, the total property investment in China grew 7% year-over-year (or YoY), which is 0.1% higher than the growth record a year earlier. The investment in residential buildings grew 9.4% YoY. The newly started floor space also grew 7% YoY in House prices

9 In December 2017, the growth in the cost of new housing in China accelerated for the first time in the last 13 months. The prices for new homes in China rose in December after cooling off in November The average cost of new housing grew in China s 70 major cities grew 5.3% YoY in December. On a YoY basis, home prices grew in 57 out of the 70 cities surveyed, compared to 50 cities in November. C hinese authorities are making efforts to slow down the country s overheated property market. UBS believes the government s efforts should bear fruit in The firm mentioned that after the authorities cracked down on speculative buying, real estate purchases slowed down. C LSA s (C redit Lyonnais Securities Asia) property market analyst in Hong Kong, on the other hand, believes China s property prices are going up not just in 2018 but possibly in the next three to five years. A crackdown by Chinese authorities on the property market could mean tougher a time ahead for iron ore miners. While Vale (VALE) is the largest iron ore producer based out of Brazil, BHP (BHP) (BBL), Rio Tinto (RIO), and C leveland-c liffs (C LF) have their major seaborne operations in Australia. China s Auto Market Expected to Grow 3% in 2018: Impact on Iron Ore Auto sales Auto sales (XLY) in C hina grew 0.1% year-over-year (or YoY) to 3.1 million units in December This growth rate is lower than the 0.7% recorded in November December marked the seventh consecutive month of growth in auto sales for the country. The total vehicle sales in China totaled million units in 2017, 3.0% higher than vehicle sales in 2016.

10 The C hina Association of Automobile Manufacturers (or C AAM) had originally forecasted growth of 5.0% in total vehicle sales for However, after the weaker-than-expected data for the last couple of the months, the association downgraded its expected growth to 3.5%. The actual growth came in even lower than this number. Compared to growth of 3.0% in 2017, China s vehicle sales grew ~16% in Impact of the tax increase A cut in the tax rate on small-engine vehicles from 10% to 5% boosted the sales in The tax cut was still in place in 2017 though at a higher rate of 7.5%. This rate reverted to 10% in CAAM is expecting auto sales to grow another 3.0% in 2018, the same rate as Auto growth and iron ore Lackluster growth in the property and auto markets means the demand for steel could come under pressure. This pressure, in turn, would be detrimental for iron ore prices, which impacts seaborne iron ore players such as Vale (VALE), Rio Tinto (RIO), Cleveland-Cliffs (CLF), and BHP Billiton (BHP). Will China s Credit Growth Crackdown Mean Weakness in Iron Ore? Aggregate financing Aggregate financing in C hina (MC HI), which reflects the total funds provided by a financial system to its nonfinancial sectors and households, came in at 1.14 trillion yuan in December The figure missed economists estimate of ~1.5 trillion yuan.

11 New yuan loans China s new yuan loans in December 2017 totaled billion yuan, which was 460 billion yuan lower than the loans a year ago. The actual growth in loans was much lower than the expected 1 billion yuan. Loans were also their lowest since April While loans disappointed in December, in 2017 as a whole, loans reached a record high of trillion yuan. The slowdown is December might also be due to seasonal factors, as bank lends less in the last months due to tight loan quotas and capital charges. M2 money supply growth The M2 money supply which includes cash, checking deposits, savings deposits, money market mutual funds, and other time deposits grew 8.2% from December 2017, which was 3.1% lower than the growth recorded a year ago. It was also much lower than the 9.1% expected. The growth in M2 also hit a record low in December. All the above factors showed a deceleration in the credit growth in the C hinese economy for December While this could be a temporary phenomenon, analysts also believe this could be a start to C hina s longstanding aim of cutting down financial risks. Most economists believe the current pace of credit growth should ease in 2018 as monetary policy tightens to avoid financial risk. Slower credit growth, in turn, could also mean lower demand for steel as well as iron ore, which would be negative for raw material suppliers (XME) to steel mills such as Rio Tinto (RIO), BHP Billiton (BHP)(BBL), Vale (VALE), and the Asia-P acific division of C leveland-c liffs (C LF). Iron Ore and China's Industrial Production and Asset Investment Industrial production and fixed asset investment Industrial output measures the output of businesses involved in the industrial sector, while fixed asset investment (or FAI) measures capital spending. It s a good indicator of investment occurring in a country or region.

12 Industrial production C hina s industrial output rose 6.2% in December 2017, which was slightly higher than the 6.1% year-over-year (or YoY) growth recorded in November The increase in December also outpaced the forecasted growth of 6.0%, according to a Wall Street Journal poll of economists. The industrial output in December also recorded growth of 0.52% month-over-month. Investors should note that the C hinese economy had grown at a faster clip in 1Q17 and 2Q17, when industrial production saw growth of 6.9% YoY. Some observers believe it to be the sign that the world s second-largest economy has peaked in the first half of The slower growth toward the later months could also be due to tighter rules on production for polluting industries. FAI slowed down In line with industrial output, China s FAI also reflected signs of a slowdown in the later months of In 2017, FAI grew 7.2% YoY, which is a marked slowdown from the growth of 7.5% recorded in the first three quarters of the year. The private sector s fixed-asset investment rose 6.0% in 2017, which is also a decline compared to the investment in January October last year. What does this mean for iron ore companies? Usually, FAI and industrial production are considered the barometers for economic health. Both these variables are showing signs of a slowdown. The slowdown, however, seems to be measured and anticipated by policymakers. They re expected to follow steady money and credit growth. Steady growth should keep supporting steel output growth, which should be positive for iron ore prices. It should benefit the companies producing high-content ore such as Rio Tinto (RIO), BHP (BHP), and Vale SA (VALE).

13 While C leveland-c liffs s (C LF) Australian division is negatively impacted due to discounts for sub- 62% iron ore, the company isn t too worried, as its main exposure is to the domestic US (SPY) (SP X) steel market.