What’s Next for Iron Ore and Coal Prices?
Having travelled to China many times over the past 15 years, the pace of change still continues to intrigue and amaze me. In contrast, the pollution and typical smell, that of burning coal, as I arrive into Beijing on a Sunday night does not!
The intention of this flying four day trip was to get a better understanding of iron ore and coal pricing issues. On the first day I was greeted with a rare event – a beautiful blue sky day in Beijing. This was followed up the next day by another clear blue sky when travelling into the industry heavy Hebei district. This was even more incredible given pollution was at such extreme levels there recently that schools were closed as the Air Quality Index reached levels of 220, versus acceptable levels of 25.
Australia has been benefitting from some very high coal prices that have been driven by shortages within China. The shortages have essentially been caused by some extreme supply side reforms that prevented coal mines from working on weekends called the 276 day rule. The reforms were designed to take out excess capacity in the system and raise thermal coal prices to enhance returns for producers that were struggling. According to SXCoal’s thermal coal cost curve, around 50% of China’s production was unprofitable in June 2016 when prices were below RMB400/t.
Unfortunately the combination of an abacus miscalculation of the supply and demand balance and stringent implementation of the 276 day rule (including having government officials ensuring no work took place in large mines on weekends) resulted in shortages in both thermal and coking coal – with the latter being the innocent bystander of the regulatory forces trying to manage price and volume of the 3.2 billion tonne thermal coal market. The government policy has obviously overshot its objective, with coal prices exceeding RMB700/t and power producers struggling to adjust. The National Development and Reform Commission (NDRC) induced China coal shortage prompted coal-fired power generators and steel mills to seek additional coal off the seaborne market and thus transferred an internal issue to a world that was completely unprepared.
Speculation within the coal and iron ore market has picked up substantially as prices have risen – particularly but not exclusively in the futures markets. Regulators have recently required higher and higher deposits and are also now charging greater transaction fees for trades given the sheer number of trades per day. It appears that mum and dad investors have found new ways to make money after the stock market bubble in 2015. Garlic is even being speculatively hoarded and prices have risen some 50%.
The NDRC is now scrambling to fix the coal shortages and price escalation caused by the 276 day rule. However, the strength in the coal price is not motivating producers to increase production to bring the price down. A number of measures have been introduced by the NDRC recently including:
Allowing all coal mines with safe production to produce at the 330 day production quota that implies up to 15-20% increase in production on August levels. This is only a temporary measure to prevent thermal coal shortages during the peak power winter months. The expectation is the NDRC will continue with the 276 day policy given its strong desire for capacity cuts and eliminate oversupply conditions in the long term;
Enacting a complicated long term contract price between the large State Owned Enterprise (SOE) coal and power producers with a base price of RMB535/t plus a “floating’ price”. The floating component moves around with the spot price and the Bohai-rim Steam Coal Price Index (BSPI).
Supply side reform and the environment
The key theme that often emerged amongst the various industry contacts was that supply side reform to the material sectors has become not only a priority of Beijing but also has finally gained popularity among local government officials. Environmental issues have also become more powerful now that the environmental agency is centralised. There is now intense focus on tailings, remediation and water with many mines across different commodities being shut, virtually for good. It appears that the central agency has been quite shocked at some of the operating conditions with tailings and waste just being released into rivers and other water reservoirs. In a report recently released by the Shanxi Environmental Protection Bureau, 29 out of the 100 surface water sites tested were found to be so polluted such that they were no longer suitable for human contact/use. Shanxi is China’s largest coal producing province and thus the 26% of China’s coal is at risk of either higher operating costs or reduced production. Hebei’s capital city, Shijiazhuang, has announced it will ban steel production and several other kinds of industrial activity from 17 November to 31 December due to severe air pollution. The city has suffered from continuous smog since mid-September which has triggered the ban. Hebei has six of the ten worst air polluted cities in China.
China’s State Council are also sending out inspection teams to investigate illegal capacity expansions in coal and steel.
Consistent with environmental and supply reforms, many companies commented that the recent crackdown on overloading of trucks has substantially reduced capacity of haulage and has had a commensurate impact on increasing transport costs. An aluminium producer commented that they were struggling to transport billet south and apparently coal transportation costs from Shanxi to Tangshan has increased from RMB130/t to RMB230/t (up 76%).
The unintended shortages of coking coal caused by the 276 day policy are being exacerbated by coke ovens regularly closed during pollution events and the trucking load clampdown. The measures introduced by the NDRC to increase coal production are aimed at thermal coal but should also result in coking coal increases. China’s coking coal demand exceeds domestic production and thus the price squeeze has been extreme and has dragged up high grade iron ore prices. Steel mills, particularly the small producers have been chasing imported high grade iron ore on the spot market to reduce the consumption of coke in the blast furnaces. Coke now makes up around 40% of a steel mills cost compared to a typical range of 20-25%. The rule of thumb is that every one percentage point increase in iron grade, reduces coke requirement by 2%.
According to Shanghai Metals Market (SMM) there are about 2,300 iron ore mines spread amongst 27 provinces with a total capacity of 425 million tonnes (mt) per annum. Concentrate production is estimated to fall from 232mt to 195mt year-on-year. Costs at iron ore mines in China remain higher than the majority of imported ore and thus domestic mines are still trying to reduce costs. Many of the SOE iron ore mines are attached to SOE steel mills and are thus less price elastic compared to privately owned mines. Nevertheless, a combination of reserve depletion, costs and the environmental issues suggest that much of the apparent 425mt capacity is unlikely to ever come back online.
The property market
The housing boom in China during 2016 has been driven by sales that are up some 25% year-to-date and Gavekal is estimating that sales will reach 1.55billion square metres for the year which is well above the 2013 peak. An unprecedented boom in mortgage lending and multiple supportive polices from local governments has brought forward housing purchases and created a credit–induced price spike. The decision by policymakers to expand leverage in the household has had the impact of reducing the massive nationwide housing inventory from around 36 months to 24 months. However the fall in inventories was not even, with inventories falling substantially in the most attractive cities (Tier 1 & 2) and remaining stubbornly high when compared to the southern and eastern provinces. The inventory problem for non-residential property at over eight years makes residential inventory look pedestrian. I heard the usual anecdotes about ghost suburbs and that there are overbuilt shopping malls being used as logistic centres.
The ultimate result of the decline of inventories was a recovery in construction activity given the oversupply was discouraging new construction in a number of provinces and cities. Housing starts were up 12% year-to-date after a decline of 14% in 2015. Although the construction activity improvement is real, the surge in steel prices is disproportionate to the moderate pick-up in demand and investment.
The extreme price rises in the Tier 1 & 2 cities has resulted in 20 cities now tightening purchase restrictions resulting in the slowing of housing credit growth and thus sales have fallen. Serious tightening does not appear to be on the agenda particularly with the 19th National Congress taking place late next year.
What does it all mean?
The net result of my visit to China is to conclude that a large policy error has resulted in severe shortages in both thermal and coking coal, rather than any increase in underlying demand. The price reaction has been severe and has been helped by increased speculation on both the physical and on futures markets. The iron ore price has been dragged higher as steel mills are increasingly trying to source high grade imported iron ore in an environment where production from the big four ( BHP Billiton, Rio Tinto, Vale andFortescue Metals ) has been relatively flat.
The new production initiatives from the government should eventually bring the system back into balance but it is difficult to gauge the time frame accurately. It is not unreasonable to expect prices of both coal and iron ore to remain higher than normal for a few more months, but with the speculative froth reducing as the government takes action to address the excess trading on the futures exchanges. Without further stimulatory activity from the government, coal and iron ore prices should move lower.
It is encouraging that we are finally seeing both local and central governments focusing and implementing on environmental and supply issues. Although the housing market in China is still the leading driver of demand for steel and cement, the tighter mortgage rules and resumption of home purchase restrictions is likely to adversely impact demand. An increase in infrastructure spending has the potential to offset this somewhat but is unlikely to increase steel demand.
Nikko AM Australia does not see any reason to change our underlying long term view that China’s consumption of commodities will reduce over time, as property and infrastructure fixed asset investment fades. In the short term, the only constant is uncertainty regarding direction and quantum of government intervention.