So the circumstances are much brighter for iron ore miners, or are they? For many of the smaller producers with lower grade ore they are still only receiving USD 38/t for the 58 per cent Fe product. Due to a substantial widening of the 62 per cent – 58 per cent price spread these producers are in a similar position to late 2015 when mines were closed and a number of corporate restructurings occurred.
The graph below illustrates the progressive widening of the high and low grade price spreads relative to the 62 per cent Fe CFR China benchmark index.
Iron Ore CFR China Price Spreads versus 62% Fe benchmark
Producers of lower grade ore initially considered the discount for 58 per cent Fe grade was transient and would soon revert to historic norms. As time passed and the discount has widened, these miners characterised the effect as “medium term” with their typical guidance revised to a 25-30 per cent realised price discount to the 62 per cent benchmark. Producers who sell a relative higher-grade of haematite fines products see this pricing differential as a longer-term change
The wider quality price spread is a long term structural change in the iron ore market. During the Melbourne IMARC conference we discussed this topic with Li Xinchuang, Vice-Chairman of the China Iron and Steel Association. The insights from that discussion are:
- China’s industrial expansion in basic materials such as steel, cement and metallurgical products was initially a quantity strategy. In these sectors China dominates global production typically with a 40-50 per cent share (China consumes 83 per cent of Australian iron ore production). The quantity strategy phase is largely over. Since 2016 China has pivoted its industrial strategy to quality.
- The quantity growth phase left a number of unwanted legacies including environmental degradation, supply surpluses and low capacity utilisation, poor industry profitability and a lack of capacity to pay down excess debt. In each industry China has embarked on rapid supply-side reform, which unlike previous announced programs is actually being implemented. The reform actions share common characteristics and benefits.
It is China’s solution to the pressing problems of pollution and reducing the debt burden of State Owned Enterprises.
Progress in China’s steel industry has been rapid. Driven by government reform, 150 m tonnes p.a. of scrap fed induction furnace capacity has been closed, eliminating the most polluting plants. Over 110 m tonnes of smaller blast furnace production has been closed. As steel profitability has recovered, these plants remained closed. Industry capacity utilization has improved but the reforms will continue accelerating as winter approaches.
Similar supply reform in coking and thermal coal, and aluminium smelting has restored global balances and driven recovery in margins in these sectors over 2016-17.
Substantially higher coking coal prices plus reform in the steel industry particularly on air emissions, have driven the preference of blast furnaces for higher iron content ore which increase efficiency and confer higher value-in-use on these high grade ores. The same forces are driving the expansion of discounts for lower Fe grade ores and ores with higher contaminants.
The root cause of this change is supply-side reform of the Chinese steel industry which is likely to be ongoing and permanent. That reform is being rolled out across many heavy industrial sectors as a national strategic priority to resolve air pollution and SOE debt problems.
Demand by China for iron ore product is likely to remain around current levels in the near to medium term, however greater demand for high-grade clean product as a result of the supply-side reforms is likely.
Junior iron ore producers of 58 per cent Fe ore can be expected to earn narrow cash margins that may be inadequate to fund sustaining investment, exploration and repay debt. Strategies will need to be implemented to address lower profitability and cash flow constraints that will be experienced by such lower grade miners under existing operational cost structures.
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We have recently published our National Resources Insight 2017, read more on the state of the market across the commodities here.
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