Commodities | Aug 12 2021
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The iron ore price may have shot too far to the downside near-term, but analysts expect prices could be lower still going forward
-China's plans to cap steel output weighing on iron ore price
-Bear market in iron ore could take hold later in 2021
-Yet this is not automatically the case for iron ore miners
By Eva Brocklehurst
Many analysts expected the iron ore price would hit its heights early in 2021 and then turn, spurred lower by weaker demand from China.
Yet the price hung on and when there was a slip, the call would ensue: is now the time? In July the iron ore price rose sharply from US$160/t to US$230/t before retracing just as quickly to US$160/t. While a retracement was widely expected, and despite the metal's volatile "boom/bust" history, Morgan Stanley acknowledges being somewhat surprised by how fast this occurred.
The latest price response came amidst concerns that China plans to cap steel output at 76.5mt in 2021, a -4% reduction on 2020 levels. China's demand for iron ore in its steel furnaces is by far the key element in the outlook for the metal.
Citi notes most observers are sceptical that China can restrict 2021 output to 2020 levels as year to date production is up 11.8%, yet acknowledges some mixed messages have unnerved traders.
Credit Suisse believes Chinese steel makers are increasingly of the view that the government is serious in its intentions to cut output. Restrictions are now in place across several provinces and, therefore, the price has weakened as mills refrain from bidding for cargoes.
The broker expects the iron ore price will decline in the second half of 2021 but, as before, in the short term it may have overshot downwards. Chinese authorities had opportunistically applied restrictions in the summer, when construction eases back anyway.
Yet restocking for autumn production would normally lift the iron ore price in August and the current uncertainty regarding delays in construction projects and the resurgence of coronavirus could be behind any absence of a rebound.
The extent to which China can slow down steel production depends on demand in the second half, Credit Suisse asserts. If demand remains anywhere near that seen in the first half steel stocks will be rapidly reduced and prices should start to spike.
If the price of steel climbs too high then construction budgets will be shattered and Beijing will need to rein in its desire to cut steel output. This is the key uncertainty in the second half, Credit Suisse believes, and ultimately steel demand will control demand for iron ore.
On average, China's steel production peaks in May and moves down sharply in November with the onset of the winter. Citi assesses monetary conditions point to a further moderation in steel consumption over the balance of 2021.
The broker expects those steel mills which were unconstrained in terms of production will enjoy improved profitability amid higher prices and lower input costs and demand for high-grade iron ore should increase.
Furthermore, with mill margins strengthening there will be renewed interest in higher grade feedstock, the broker suggests. Over the longer term decarbonisation will also support demand for higher grades.
Bear Market Parallels
The question Longview Economics contemplates is whether the fundamentals currently in play run parallel with the GFC. From 2009 to 2011 the iron ore price sustained its strength amid fiscal stimulus, central bank liquidity and a rebound in major countries from a deep recession.
What followed was a multi-year phase of escalating production and a slowdown in Chinese demand growth, which fuelled a bear market from 2011 to 2015. Longview Economics asserts the outlook for the next few years is consistent with this post-GFC trend.
Chinese construction activity is likely to slow and remain relatively weak and this is a key driver of global iron ore demand, therefore highly correlated with the price. As a result, credit growth in China should remain weak.
Moreover, once the recovery from the pandemic has been achieved China is likely to revert to pre-pandemic policies for deleveraging the financial system. In turn, this should stymie construction activity.
On the supply side a significant response to high prices is expected by the end of 2021 and strong growth in production likely in 2022. Hence, Longview Economics argues a large iron ore surplus is likely and prices will then begin to break lower.
Morgan Stanley agrees with the assessment that the current demand-driven sell-off may level out by the end of the northern summer and a slower supply-driven bear market take hold later in 2021.
Descent To Where?
The issue is then about to what level the price will ultimately descend. The broker notes, reviewing past bear markets, that demand-driven corrections happen fast while supply-induced corrections tend to take longer. Since 2008, Morgan Stanley highlights eight large sell-off events for iron ore, with an average correction in the price of -US$65/t, or -40%, and an average duration of 120 days.
Projecting past dynamics onto the current market, the broker suspects the current correction may have more to run but could be countered by improving end-use demand when China's construction activity picks up in late August and September.
Yet for more price support, clarity on environmental production cuts is also required. Morgan Stanley expects the seaborne market to return in the second half to a supply/demand balance more akin to the fourth quarter of 2020 when the iron ore price averaged US$134/t.
The broker points out a "typical" rapid -40% correction from the heights of July would bring the price down to the low US$130/t level. Moreover, the market is likely to start focusing more on supply, and the fourth quarter could produce the strongest shipment volumes of the year.
Conventional wisdom that anticipates iron ore equities will follow iron ore prices lower is not really borne out by the facts, Citi asserts, citing the example of Fortescue Metals ((FMG)), the shares of which have underperformed the iron ore price since October 2020 in what appears to be a steady risk-off trade.
The broker acknowledges investors are torn between cash returns and the potential for lower share prices, should the iron ore price retrace further, yet still envisages strong dividend pay-outs among iron ore stocks, assuming prices hold at US$125/t in 2022 and US$80/t in 2023.
Taking this into account and the strength of miner balance sheets, any sell-off in iron ore stocks may be less than many fear, as dividend support will attract investors back.
Morgans assesses June quarter operations at Rio Tinto ((RIO)) and Vale were surprisingly weak and this puts pressure on the 2021 guidance for both iron ore miners.
While Vale continues to reassure the market about the risk profile of some of its tailings dams, the broker will be watching volumes from the September quarter closely given this is usually a seasonally stronger output period.
For Rio Tinto, the December half-year is also a critical time for bringing on replacement mine capacity and the company is having to content with the underperformance that stems in part from labour constraints.
Morgans continues to recommend caution, as iron ore price risk is outweighing the appeal of strong company fundamentals.
In the case of BHP Group ((BHP)) and Rio Tinto the broker retains Hold ratings, as the dividends are filling some of the valuation gap. Morgans has a Reduce rating for Fortescue Metals, which is expected to keep underperforming amid a growing discount for low-grade iron ore.
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