Iron Ore: As good as it gets
About the author:
- Author name:
- By Adrian Prendergast
- Job title:
- Senior Analyst
- Date posted:
- 17 June 2021, 4:00 PM
- Sectors Covered:
- Mining, Energy
- Lofty market valuations and potential early signs of moderation leave us nervous.
- Peaking global steel demand has been exceptional but will be tough to sustain.
- Flat inventories indicate a lack of tightness in the iron ore market, but there is little doubt the cost curve has steepened to keep the market supplied.
- High cost tonnes currently keeping the iron ore market balanced are likely to be displaced by rising low cost supply in 2H.
- Speculators have added to tightness, pushing spot prices to current lofty levels.
Global steel demand unsustainably high
Riding a surge in steel prices, Chinese steel production climbed in April reaching a record annualised 1,176mt (+12% vs 2020). Steel demand in China has been supported by heavy stimulus, which has fuelled a rapid economic recovery from COVID. In particular this has seen rising infrastructure fixed asset investment (FAI) (+5% yoy January-April), and a strong resi property market (property sales YTD at 5-year highs).
These are material drivers given we estimate FAI and resi property account for 48% of Chinese steel consumption, while the global COVID-19 recovery ex-China has also started to support broader steel demand growth.
Despite the record steel output, iron ore demand actually sits ~20mt below peak 2020 levels. We attribute this to a jump in scrap steel usage in China. Electric arc furnace (EAF) output, which uses scrap steel instead of iron ore and met coal as the raw material, has been rising.
We attribute this to the higher steel prices, overcoming the EAF’s high-cost base. We estimate scrap-supported EAF production now makes up 12% of Chinese production, up on historical averages but still well short of China’s target to have scrap constitute 25% of steel output.
While there is still some upside risk from areas such as manufacturing investment, we expect China’s FAI and property markets to slow down as we head into H2, as China pulls back stimulus post recovery
Supply a mixed picture
Aggregate iron ore supply is on track to continue rising in H2, but equally, the market is poorly positioned to sustain any unexpected supply losses.
In addition to rising scrap steel usage in China, we have also seen a pickup in domestic iron ore production, which could add 80-100mt of new supply in 2021.
Heading into H2 we expect Brazilian supply to continue recovering. Brazil iron ore exports are already up +12% YTD, with the December half seasonally higher. If Vale can avoid any further dam incidents we see it in good shape vs guidance.
Also implying a lack of tightness, China port iron ore stockpiles are flat this year at a steady ~120mt. This supports our view that speculators are driving a portion of the current spot price strength in iron ore, which has eclipsed all other steel prices and raw materials.
Any unexpected supply losses would see further spot price upside, but all else being equal we see iron ore fundamentals as likely to ease in H2. It will be interesting to see if slowing fundamentals trigger selling from speculators.
Based on past commodity cycles, as the cycle matures we expect equity market focus to switch from earnings momentum to earnings direction (i.e. spot price trumping consensus upgrades). Market forecasters also have a tendency to ‘overshoot’ each phase of each cycle in adjustments to assumptions, mistaking cyclical factors for structural as a cycle extends. This leaves us nervous at current lofty market valuations despite the chunky dividends on offer.
How to play peak iron ore
While preferring BHP Group (BHP), we view both BHP and Rio Tinto (RIO) as core portfolio holdings for yield investors and maintain our HOLD rating. While trading near fair value, they have dividend yields of 6.5% and 7.5%, respectively. For more active investors we would view further share price strength as an opportunity to take some profit.
Fortescue Metals (FMG), whose DCF valuation moves by a significant A$3.90ps for every US$10/t move in iron ore price, we view as overvalued with a REDUCE rating. Despite its success we see FMG’s current share price premium to valuation as overwhelming its attractive yield appeal.
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