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2 reasons iron ore is rallying, and what could make it stop

Mark Dadswell/Getty Images

After a shellacking earlier this year, iron ore markets have sprung back to life in recent months, seemingly out of nowhere.

The benchmark spot price for 62% fines has jumped over 40% from mid-June, according to pricing from Metal Bulletin, creating a rare bit of excitement in what have been otherwise sleepy financial markets.

While wind swings are nothing unusual for iron ore markets, as demonstrated in the chart above, the key questions that many investors are now asking themselves is what has been driving the recent resurgence, and whether it can last.

Fundamentals and speculative factors have all been cited. Analysts, as is so often the case, are spit on what the future holds.

Vivek Dhar, mining and energy analyst at the Commonwealth Bank, is the latest to wade into that debate, offering two reasons why prices have been rallying hard over the past two months.

Here’s his take from a research note today:

Iron ore prices have lifted above $75 a tonne as Chinese steel mills look to boost steel output as steel rebar prices continue to track higher. Rising consumption from China’s property, infrastructure and manufacturing sectors has been a major influence on China’s stronger steel prices this year. China’s smaller cities, which account for the lion’s share of the nation’s property construction volumes, has continued to show promising signs. Infrastructure investment has increased by around 21% year-on-year in the first half of 2017 as the Chinese government looks to support economic growth ahead of a leadership transition later this year and a government reshuffle in the first quarter of 2018. China’s official manufacturing index has also remained expansionary for the first seven months of the year.

So strong demand has been one factor, aided by a desire from the Chinese government to ensure the economy is humming as parliamentary elections are held.

However, that’s not the only factor that has been driving prices higher, says Dhar:

Government plans to reduce overcapacity and reduce pollution has also helped keep steel prices higher by limiting China’s steel supply growth this year. Authorities are cracking down on induction furnaces, which produced 65-70 million tonnes of steel last year. These furnaces have been targeted because they produce low quality steel products (mostly rebar) and have remained outside the radar of regulators (and official statistics). However, the reduction in steel produced via induction furnaces, which utilise mostly scrap steel, has opened the door for Chinese blast furnace steel makers to boost output. Blast furnace steel mills predominantly use iron ore. As a result, China’s iron ore consumption has received further support. That narrative though is facing increasing pressure as scrap steel usage has increased too, offsetting the impact of higher blast furnace steel output.

So another fundamental factor underpinning iron ore demand, helping to explain why iron ore imports and seaborne spot prices have been so strong of late.

However, while that helps explain what has happened, what most investors want to know now is whether that will continue to support prices.

While no one knows that answer for sure, aside from Chinese policymakers, of course, Dhar says there’s one area that investors should pay close attention to for clues as to when the rally will come to an end: Chinese steel mill margins.

“We continue to believe that as long as Chinese steel mill margins remain elevated, iron ore prices should remain at current or higher levels,” he says.

“The Chinese government policy backdrop also suggests that iron ore prices are unlikely to sustainably fall to $40-50 a tonne level this year.

“China’s commodity intensive sectors likely have the green light over the next 6 to 9 months to help keep economic growth ticking over.”

If correct, that suggests there may be further for the iron ore rally to run yet.

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