Something has to give in the Chinese steel sector, given the disconnect between record low steel prices and a recent strong rally in iron ore.

Steel rebar futures hit a record low on Tuesday, with the benchmark contract dropping to 2,238 ($360.47) a ton, the weakest since the Shanghai Futures Exchange launched the contract in 2009.

Futures ended at 2,266 yuan a ton, bringing their loss for the year so far to 15 percent. The contract has lost two-thirds of its value since its record high in August 2009.

While Dalian Commodity Exchange iron ore futures did drop on Tuesday, falling 1.4 percent to end at 442.5 yuan a ton, the contract rallied 21 percent between its record low on April 10 this year and the recent peak on June 11.

The iron ore and steel contracts show a strong correlation over the last few years, but this has broken down in the past week as steel futures plunged and iron ore only weakened slightly.

The obvious way for the correlation to be restored is for iron ore prices to decline to match the slump in steel rebar, and there is certainly strong reasons to believe this will be the case.

The recent rally in both iron ore futures and the spot price, which has gained 33 percent since its record low of $46.70 a ton on April 6, has been driven largely by some weather-related supply disruptions and increased buying by steel mills as inventories at Chinese ports declined.

With more supply from major producers Brazil and Australia expected in the second half of 2015, and lackluster steel output and demand growth in China, the likelihood is that iron ore prices will decline once again.

However, the Dalian futures curve <0#DCIO:> isn't indicating that a sharp decline is likely, with the curve largely flat between three and 12 months, with just 10 yuan a ton separating the contracts.

The Dalian curve has been backwardated for at least 18 months, although the curve has flattened dramatically in the past few weeks, with the three month contract now only 2.4 percent above the 12 month, whereas it was 7.2 percent on May 15.

The shape of the curve isn't really a useful predictor of the actual level of prices, but it can point to future direction, and it's currently saying that steep declines are unlikely over the longer term.

However, the Dalian curve is still strongly backwardated between the front month and the third month, indicating that the immediate pressure for iron ore prices is downward.

STEEL RALLY UNLIKELY

Are there alternatives to iron ore prices declining to match the recent slump in Chinese rebar prices?

There isn't much support for a demand-led recovery in steel prices, given the soft outlook for demand in China, with the China Iron and Steel Association forecasting last month that consumption will decline 6 percent this year.

Steel output fell 1.7 percent in May from a year earlier, and is down 1.6 percent in the first five months of the year, according to data from the National Statistical Bureau.

With slowing demand in China, one of the few bright spots for the sector has been exports, with outbound shipments of steel products jumping 28.2 percent to 43.52 million tonnes on the first five months of 2015.

But rising exports are unlikely to be enough to boost steel prices significantly, given the over-capacity that still plagues the industry.

The best hope for a recovery in steel prices in China is a combination of smelter closures and stronger demand from rising infrastructure spending in the second half of the year.

There is some hope of capacity cuts, with plans to cut 80 million tonnes in the next three years, although this still may not be enough to balance the sector.

China's state planning agency recently released a list of 1,000 proposed projects worth about $318 billion that it's inviting private investors to help fund, build and operate.

While these hold out hope for the steel sector, the big question is how many can be delivered and over what time frame.

In the meantime, the most likely scenario is that iron ore and steel prices continue to explore the downside until prices are low enough to force supply from the market.

 

reuters.com

Report Abuse