Commodities | Sep 25 2013
-Market may be too price pessimistic
-Large iron ore oversupply unlikely
-Chinese economic resilience key
-India the wild card
By Eva Brocklehurst
The market is fearful that iron ore prices will become hostage to increasing oversupply, and fall, mimicking the precipitous declines that took place late in 2012. This is predicated on forecasts for seaborne supply to increase along with reduced demand from China. It may not happen. Iron ore prices currently have surprised on the upside, as both supply and demand support the strong prices.
It is a fear that Morgan Stanley believes is largely unfounded. The analysts suggest the market has a poor record for anticipating supply and demand fundamentals in pricing expectations. While Morgan Stanley expects supply growth will outdo demand from the second half of 2014, until it actually happens, the price is expected to reflect tight supply. When it does happen, demand is expected to still be modest and Chinese steel production should maintain a healthy growth path. On the supply side, Morgan Stanley thinks the market will be under supplied in the first half of 2014 and shift to a moderate oversupply in the second half.
CIMB is in the same boat as Morgan Stanley, having reviewed historical forecasts of iron ore supply and found that the market routinely over estimates supply by as much as 450m tonnes in some years. Unexpected events such as the GFC in 2008 may have caused demand to drop sharply, but generally supply has been overestimated. The bear case for iron ore prices relies on expectations that supply via the global seaborne market will confront domestic supply in China and create excess. Morgan Stanley notes a number of small misses in output this year from the key exporters could explain why the market for iron ore is still in deficit, but even with full production rates the resilience of Chinese demand would have ensured a tight market.
Critically, steel demand and production in China have benefitted from targeted stimulus that has been aimed at stabilising the economy. This is one of the key reasons as to why Morgan Stanley thinks the market is overly pessimistic. The current resilient pricing should continue into 2014. CIMB does not expect the market to move into surplus until 2015. Then prices might ease, but they won't fall off a cliff. As the oversupply is expected to be at around 3%, prices should stay firm. CIMB forecasts US$130/t in 2014, US$127/t in 2015 and US$121/t in 2016. Moreover, the broker thinks the market will get around to upgrading price forecasts as growth in supply disappoints and Chinese steel consumption forecasts are re-based after a strong 2013.
For Morgan Stanley, if supply is tighter than previously expected, the bull case scenario has a US$156/t price forecast for the December quarter and US$140/t for 2014. The base and bear case scenario is for iron ore prices to average US$125/t CFR China in the fourth quarter and US$117/t over 2014. Fortescue Metals ((FMG)), the most leveraged Australian stock to iron ore, has been implying US$105-110/t based on recent share prices. Exposure is warranted, in the broker's view, underpinned by price forecasts that remain above this level through to 2015.
The iron ore price has not been so volatile this year, compared with last year's machinations. Morgan Stanley thinks this is because steel mills are carrying much lower inventory. Hence, sharp de-stocking and re-stocking is limited. The decision to carry less stock is strategic as well as market driven. Strategic in the sense the Chinese mills have restricted cash flow and tighter balance sheets, and market driven in the sense any industrial user tends to run with less inventory during times of price volatility.
Goldman Sachs has also weighed in on iron ore inventories at the steel mills, which remain near functional lows at around three weeks of use, noting that mills do not have the capacity to deliver an industry-wide de-stocking event similar to that experienced in September 2012. So, incremental buying support appears to have dampened volatility in the seaborne market and assisted the seaborne price to stay near marginal cost levels.
Will China’s recent growth acceleration be sustained? That's the question Morgan Stanley has asked, and has answered. It largely depends on how the government successful in stabilising growth with policy measures. The broker's view is that the fiscal support is quite significant and by the time it runs out of steam at the end of this year, growth will be softer next year. From the start of next year, Morgan Stanley is concerned the Chinese economy will face headwinds from the de-leveraging process. So, will industrial demand stay firm as China enters a phase of much lower credit growth? Morgan Stanley's base case assumes a smooth transition, but not an easy one.
Outside of China, Morgan Stanley expects that recent broad-based improvement in Europe and Japan should translate into moderately higher steel production. Growth of 3.8% in ex-China steel production is forecast for 2014 and 3.5% for 2015. What is the rogue factor in all of this? India. Indian iron ore exports have been difficult to project. India's Supreme Court is currently considering lifting mining bans in two of the country's largest iron ore producing states in order to address the current account deficit. Goa could be the first. Goa used to supply around half of India's total iron ore exports. Morgan Stanley suspects that, should restrictions be lifted, there could be up to 12mt at the ports for immediate delivery. Beyond that, the broker thinks it will take some time for Indian producers to obtain the proper licences to re-emerge in the seaborne market with any size.
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