The 2013 Chinese steel surge & iron ore forecasting

Chinese steel production has proven to be much stronger than anticipated in 2013, with iron ore the key beneficiary. And because iron ore price forecasting is primarily about forecasting the Chinese domestic iron ore production requirement, the much stronger data in 2013 will potentially flow through to stronger forecasts in outer years as well.

But analysts will have to beware of the level of iron ore consumption further out in the profile, which will be much stronger now that the 2013 base is much higher.

Firstly, it looks like September steel production should come in at ~765mt ann given the early read from CISA and the likelihood that production rates remain pretty healthy.  That would be 9.1%YoY than last year.

Assuming a decent Q4, (which currently looks good given leading indicators and inventory positions), full year steel production will be ~765-770mt, or up ~7.5%YoY.

This is much better than anyone was forecasting at the start of the year, or even mid-year when steel inventories were high and the macro situation was looking very shaky.  It is also much stronger than I was looking for by about 20mt.

The key impact this has on future forecasts is that it lifts the base for requirements in future years.  As discussed in more detail in this post, the key question for future iron ore pricing is dependant on how much high-cost domestic iron ore is required each year, which costs somewhere north of $125/t to produce.

At the moment, there is about 150mt of this ore being consumed, so the critical turning point for prices is when seaborne supply overtakes incremental Chinese demand by this amount.  Importantly, this is on a cumulative basis rather than in any given year.

To illustrate, the chart on the left shows the cumulative seaborne iron ore supply and Chinese demand outlook to 2016.  My previous base case forecast is in red, which assumed ~4.5% growth for 2013.

Under this scenario, it seemed likely that there was a fairly high risk that stronger seaborne supply would displace Chinese domestic supply by 2016 and prices would, on average, be quite a bit lower.

But the green line shows the new forecast assuming 7.5%YoY growth for 2013.  Crucially, growth forecasts in outer years are unchanged from the previous base case.

This means that the level of Chinese iron ore consumption is much higher at all points in the forecast horizon. It is even much stronger than what I thought were optimistic assumptions.

In this profile, it seems much more likely that the market will require high-cost production to balance (as denoted by the area in the green brackets).  Therefore, it seems unlikely that prices will seriously capitulate for an extended period of time in the forecast horizon.

This analysis only moves one part of the equation for iron ore prices, namely the 2013 base.  This is probably as much as analysts can do given the the challenge of forecasting 2014, but the key question will be whether growth next year will remain the same or will need to be changed.

I was clearly too pessimistic this year and perhaps I will be next year as well.  But to me the risk seems to be that because steel consumption was so much stronger than anticipated this year, growth is likely to be slower than anticipated next year.

For me, the policy risks appear high. The government will continue to challenge the growth model which doesn't really appear to have changed or mitigated risks to the financial system and economy.  2013 doesn't appear to be the success they were looking for, with the pick up in infrastructure and construction since mid-2013 increasing the steel intensity of GDP.  Credit growth also remains rampant despite some wobbles induced by the PBOC.

But just because growth is lower than previously expected, it doesn't mean that iron ore prices will be persistently weak.  While they may be vulnerable to inventory induced swings, it seems very unlikely that a huge amount of Chinese high-cost ore will be displaced.  But as we have seen this year, surprises in growth in 2014 will be critically important in determining when that might happen.