A structural shift has occurred in the global iron ore market as the top source of supply in Brazil has been sharply reduced. Brazil’s Vale, the world’s largest producer of iron ore, had believed it could mitigate lost production through expanding other operations but has found this difficult.
Investigations have found even more problems beyond the fatal tailings dam failure that started the ball rolling. Credit Suisse cites news reports that a rock slide at the abandoned Gongo Soco open pit is moving at the rate of 20cm a day, indicating a collapse is imminent.
ANZ analysts do not expect any material rise in Vale’s output in 2019 and forecast supply to be short of expected demand by -45mt. Macquarie also suspects a recovery to 400mtpa from Vale is likely to take longer than previously expected, noting while the company has reiterated guidance for 2019 of 307-332mt its commentary has shifted to emphasise the lower end of the range.
Shipments from Vale in April were at record lows. However, the real significance is for 2020 when the deficit could increase, as port stocks dwindle and other suppliers fail to fill the gap. ANZ analysts expect tightness in the iron ore market to linger well into 2020 and expect prices to remain above US$85/t in 2019.
Usually, across commodities, supply from other quarters quickly fills the gap from any disruptions but this is not occurring for iron ore in any significant way. Weather-related disruptions have also coincided, as Vale experienced heavy rain in its northern system in the March quarter and Australian producers were forced to lower output guidance because of Cyclone Veronica.
BHP Group ((BHP)), which cut production guidance to 265-270mt, has noted that output for the current year will fall for the first time since 2000. Rio Tinto ((RIO)) recently cut its 2019 shipment guidance to 333-343mt. Fortescue Metals ((FMG)) has not changed guidance, expecting 165-170mt.
Moreover, the ANZ analysts note Australian-sourced iron ore has experience the largest decline in stockpiles in China. Tradable port inventory for medium-grade fines is at very low levels and Chinese buyers have few high-grade alternatives for use in sinter feed.
The port squeeze has begun. Credit Suisse expects inventory to shrink further, while prices should climb before supply increases on a seasonal basis from the fourth quarter of FY19. Meanwhile, a short-lived increase in steel margins has been erased by rising iron ore prices and this has allowed Fortescue to maintain narrow contract discounts for its lower-grade ore.
Premiums for high-grade ore and discounts for lower grades have contracted since the dam tragedy. Lower grade prices, Macquarie notes, have risen by around 100% in the year to date and currently trade at around US$93/t. Higher grades have increased to a lesser extent, trading at around US$120/t.
The premium for 65% iron over 62% peaked at over 40% in August 2018 but has moved back to around 15%. Macquarie assesses the current spread of US$30/t between high and low grade remains in line with the average.
However, Morgan Stanley believes the iron ore price is now starting to find a top as output of steel in China takes a breather. Utilisation rates have fallen -1% from the peak in early May and some steel production curbs are in place in Tangshan until September.
The broker expects the current market deficit in iron ore will narrow, although not disappear, as supply modestly improves and China’s demand eases. Credit Suisse also points out the province of Hebei will reduce annualised capacity by -14mt in 2019 and 2020 and maintain capacity below 200mt by 2020.
Macquarie expects an increase in supply will come from Australian iron ore miners and this should mean the premium for lump ore will come under pressure. Pellet pricing is also more competitive in China’s spot market. Supply disruptions in the Pilbara, where the majority of lump comes from, have eased and Rio Tinto and BHP Group dominate lump supply. Fortescue Metals has recently entered the lump market, with shipments annualising close to 10mtpa.
Yet, new supply should be easily absorbed by the market, Macquarie asserts, given the expected shift to directly charge ore in China, amid growing productivity as well as environmental pressures that favour higher quality. This boost in demand means the broker forecasts the lump premium will stay above the historical average in the next few years, at around US$14-15/t versus the 10-year average of US$12/t.
Higher Prices But Not Supply
ANZ analysts believe higher iron ore prices may still struggle to incentivise new supply. Chinese domestic producers are constrained by policy measures restricting the re-opening of operations. Moreover, iron ore has slipped in terms of investment by the large diversified miners, where the focus has shifted to copper and offshore oil assets.
This leaves traditional swing producers such as India and China to fill the gap. However, much of Indian iron ore is low quality and not a good replacement for imports from Brazil and Australia. India’s high-grade iron ore imports have surged as its mills have been keen to use better grades. The analysts note there is an estimated oversupply of more than 150mt of Indian low-grade iron ore. Importing this material into China attracts a 30% duty but Indian exports to China have increased.
Beyond this low-grade source, growth appears unlikely. Morgan Stanley also flags production disruptions have the potential to force Indian steelmakers to the already-tight seaborne market, although this is not a base case.
Macquarie notes, in the long-term, development of BHP’s South Flank should supply up to 25mt of lump to the market from 2022 and the company’s lump share is expected to increase to 35% from 25%, placing it ahead of Rio Tinto in terms of lump exposure.
What is lump? Lump is a naturally coarse form of iron ore and a niche market versus the larger global trade in fines. Lump can be directly charged into the blast furnace and typically trades at a premium, equivalent to the cost of sintering fines.
The other main category, pellet, is a high quality product which requires little additional processing. Lump is considered a substitute for pellet, particularly low-quality pellet from China, and the price of pellet plays a role in the lump premium.
While a pick up in China’s pellet production is potentially bearish for lump, Macquarie finds little evidence of mines re-starting, although capacity utilisation continues to improve and the rally in spot prices creates a risk that more concentrate and pellet will come back on line.
Several other factors drive the premium in lump including Chinese environmental policy and profitability at steel mills. Chinese demand is set to receive a boost from policy measures protecting economic growth while the outlook for steel demand remains strong as infrastructure expenditure increases.