Iron ore: No choice but to obey
About the author:
- Author name:
- By Adrian Prendergast
- Job title:
- Senior Analyst
- Date posted:
- 20 September 2021, 8:00 AM
- Sectors Covered:
- Mining, Energy
- Despite trading back at lower levels, we remain cautious on our big miners expecting more short-term weakness in iron ore to unfold.
- After China steel output surged 12% in the first half, China is now enforcing strict restrictions aiming to keep 2021 steel output inline with 2020 levels.
- Bulls are getting stale quickly, and in our view are still misjudging how deeply the Chinese will cut steel output, preferring eco stability/environment over growth.
- There are still H2 risks to supply, particularly from Rio Tinto and Vale.
- Iron ore is too volatile to accumulate mid selloff, we remain bearish.
Flat 2020 steel virtually…possible
Since mid-June we have been warning about the unsustainable peaks steel demand conditions had reached. We were concerned by the speed and magnitude of growth unfolding in China. This risk is now playing out with China applying hard brakes policy wise towards growth, although in our view too late.
Demonstrated by the Evergrande issue, with the giant Chinese property developer likely to default on its US$300bn of debt and posing material contagion risks. The policy shift is already having a sharp effect with economic data uniformly weaker this month (especially property and manufacturing activity).
For steel, the Chinese government is pushing a hard policy of wanting to keep annual output for the year at no greater than 2020 levels. A difficult challenge after steel output grew at a record 12% in the first half. Steel production peaked in May at 99.4mt, but by July had declined 12.7% to 86.8mt. An ugly and sudden drop in demand that cannot be explained away by seasonal weakness.
Add on top China’s environmental targets, with the steel industry a major polluter, and the approaching Winter Olympics 2022, and we think the Chinese government means business. Meanwhile reduced steel mill profitability and lower steel exports (albeit coming off a high base) are also contributing.
More pain to come
To achieve flat steel production in 2021, we would have to see a further fall to average 81.9mt over the remaining four months (which would see an extra c32mt of lost iron ore demand). Daily production data from CISA suggests a further decrease unfolded in August, but still it remains above the pace needed.
In our view this suggests further supply cuts will likely unfold over most of the remaining months of 2021, rather than a shorter sharper drop. Several state-owned enterprises (SOE) have already come out guiding to lower second half production, while the schedule for winter supply curtailments are also restrictive through 1Q22 (ahead of the Winter Olympics).
The pain has been most severe amongst lower grade iron ore, with steel mills prioritising high grade to help minimise the amount of coke required against a backdrop of record hard coking coal prices.
On the supply front the landscape looks steady. Vale production started the year strongly but has marginally trailed more recently, with Vale still on track for its 315-335mt guidance.
Vale did recently trim 2022 capacity guidance to 370mt (from 400mt), but we note several pundits were expecting ~350mt. Meanwhile China iron ore port stockpiles have been creeping higher and sit around c130mt.
We remain bearish on iron ore in the short term and think it has further to fall. We are watching steel numbers closely but find it impossible to gain any positive conviction while iron ore is in freefall.
Given iron ore prices (and low-grade discounts) are both in freefall we also revert our valuation methodology on FMG to DCF, discounting the usefulness of current 1-year earnings multiples as a value guide. As a result we revise our target price to (login to view).
As a result we maintain our REDUCE rating.
We also maintain our HOLD rating on BHP (login to view) and RIO (login to view). Both stocks are trading around accumulate territory but again we remain cautious given the poor state of their largest exposure.
The key risk to our call would be a sharp demand rise.
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