Iron Ore: Easing Constraints, Moderating Demand

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Increasing downside risks to iron ore prices; headwinds in the form of easing supply-side constraints and moderating demand in China.

-Iron ore prices to come under pressure with increasing Vale shipments
-China’s steel output likely to ease during July-August
-Premiums on iron ore pellets at record-lows

By Angelique Thakur

All’s Vale (and may not end so well)

The iron ore price is currently hovering around US$100/t but Morgan Stanley highlights some bearish factors looming on the horizon, which compel the broker to forecast lower prices in the near future.

Vale's iron ore shipments, increasing even in the middle of the pandemic, is one such factor although Morgan Stanley remains unsure whether Brazil’s supply issues are over.

Morgan Stanley considers Vale shipments as the key swing factor in deciding where the iron ore prices will settle, noting little supply upside from anywhere else. Vale in turn depends on performance in the Northern System, which has been ramping up recently.

Vale’s shipping rate, when annualised, increases to 315mtpa, a material increment from 200mtpa in May, highlights the broker.

Vale is expected to produce 300mt in 2020 which translates to a 40% increase in ore shipped in the second-half over the first-half. However, to achieve this figure, the miner will need to increase its shipping rate to 70mtpa by December versus June.

Considering the uncertainty surrounding supply from Brazil, Morgan Stanley forecasts iron ore to be at US$95/t during the third quarter of FY20, about 14% above the consensus forecast.

The fourth quarter has been pegged at US$80/t, in line with consensus.

Brace for impact

Another factor impacting the iron ore price is the moderation of steel output in China, anticipated somewhere during July-August.

China’s demand for steel seems to be weakening due to seasonal factors, with the 3-month decline in China’s finished stocks coming to a halt.

This, along with rising shipments from Brazil, will lead to the replenishment of China’s depleting iron ore port inventories. Declining levels of port inventories have been one of the key drivers of the iron ore price surge, points out Morgan Stanley.

Come mid-August, Morgan Stanley expects arrivals from Brazil to be almost 3mt/week higher than they were over the last four weeks.

This, coupled with a moderating demand trajectory, implies port inventories will be back at their average levels as early as in the first half of September, and with prices back in the low US$80s/t by then.

Flattening the curve (not the one you're thinking of, though)

If the increasing Vale shipments and the anticipated hit to Chinese steel output weren’t enough, we also have progress on Simandou mine’s blocks 1 and 2.

A report by JPMorgan notes the Simandou mine, based in Guinea and taken over by the Chinese backed SMB-Winning consortium in late-2019, has targeted initial production at 60mtpa, ramping up in 2026.

Simandou blocks 3 and 4 are owned jointly by Rio Tinto ((RIO)) and China's Chinalco. If reports by the Chinese media group Caixin are anything to go by, Rio Tinto may have a new partner with Chinalco having sold its stake to steel producer Baowu.

JPMorgan reckons this consortium may wish to join forces with SMB-Winning so as to dilute the capital intensity, with blocks 3 and 4 potentially ending up with a circa US$150/t capital intensity.

This, however, may not please Rio Tinto with its value over volume strategy. The miner may decide to relinquish control of its stake, or may decide to plod ahead anyway so as to retain some control.

JPMorgan suspects Chinese intentions may be to lower iron ore prices in the future with savings coming at as much as US$14bn from a reduction of -US$10/t in the iron ore price.

There could be an additional 110mtpa from blocks 1-4 by 2030, predicts the broker, translating to 10% of Chinese imports, with more scope for expansion once the rail line is built.

This may represent a major threat to long term iron ore prices and could lead to a flatter long-term cost curve.

JPMorgan has not changed its US$60/t long term iron ore price. The broker wants to see where the Chinese steel production will eventually peak (as it is expected to do so by 2030) and if Simandou is needed to support steel demand.

Can’t dodge this pellet

Iron ore pellets are small balls of iron used to produce steel. Iron ore powder, generated during ore extraction, is a key ingredient of pellets.

Blast furnaces, while producing steel, can work only if the air inside can circulate freely and this is possible only if the shape of the iron ore is big enough to have spaces between them (difficult for fine iron) for the air to pass.

It is for this reason pellet prices tend to trade at a premium over iron ore fines. The seaborne pellet market has two types of products: blast furnace (BF) pellets used for producing steel and direct reduction (DR pellets) used for producing direct reduction iron.

Macquarie notes the premiums for both – BF-grade pellet and DRI pellet – are at their lowest in ten years.

65% Fe BF-grade pellet premium is at US$20/t for the third quarter, down from more than US$25/t while DRI pellet premium is at US$27/t, down from US$33/t.

According to the analysts, this loss in premium signals weak demand, hit by covid-19, among key importers including Europe and East Asia. Supply has been diverted to China but at a discount with inventories there surging to record new levels.

Macquarie expects only a limited downside from this point as the price is already below the average pelletising operating costs of Brazil, whose average pelletising cost was around US$25/t in 2019.

Any more falls in the premium would dent even the most cost-effective plants and prompt them to sell more into high-grade sinter fines market instead.

2020 will be tough for pellet producers, anticipates Macquarie, on the back of low margins, high inventories and idled steel capacity in Europe.

On the bright side, long term fundamentals remain intact with pellet charge in China’s blast furnace continuing to rise, driven by a shift to larger, more productive furnaces.

Also, the shift to de-carbonise steel making in markets like Europe and Japan may also boost pellet demand as using pellets in blast furnaces reduces carbon emissions.

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