Fundamental factors, rather than rampant speculation in Chinese commodity futures, has been the main reason behind the resurgence in the iron ore price this year, and with those factors likely to continue, the price is likely to remain well supported on any dips below US$50 a tonne in the period ahead.
That’s the view of Daniel Hynes, senior commodities strategist at ANZ, who believes that the rally in Chinese iron ore futures was merely a by-product of improved fundamentals rather than the catalyst behind the actual surge in the iron ore spot price.
“Iron ore prices have had a rollercoaster ride in recent weeks. A solid bounce in prices that started in January turned into a fully-fledged bull market in March as growth from the ‘old economy’ in China boosted sentiment,” said Hynes in a research note released on Thursday.
“This in turn saw speculators pile into the iron ore futures contracts on the Dalian Commodity Exchange, with trading volumes surging to 50 times the levels seen in January.”
And pile in they did, as demonstrated in the excellent chart below, supplied by Hynes. It shows the volume of iron ore futures traded on the Dalian Commodities Exchange, overlapping it with price movements in the underlying contract.
At its peak in mid-April, trading volumes were fifty times greater than the levels seen in January, pushing the price of the most actively traded September 2016 contract up 68% over the same period.
While the Dalian Exchange has since introduced measures to curb the speculative frenzy, something that has seen spot and futures pricing fall by more than 20%, Hynes believes that underlying factors in the physical underlying market — both from a demand and supply perspective — suggests that prices will likely trough in the near-term.
“Outside of periods of extreme volatility in futures markets, demand for physical cargoes has been consistently strong,” notes Hynes.
“This is backed up by the data – for example, steel production has increased as the housing market improved. While sales and prices have been strong for six months, we have now started to see a pickup in construction activity in the housing market in China.”
As a consequence of this acceleration in construction activity, along with low steel inventory levels shown in the chart below, Hynes suggests “steel mills started restocking as confidence of further growth in demand increases”.
Along with demand-side factors, Hynes believes that supply-side issues also contributed the rebound in iron ore price.
“We have also seen some supply-side issues help support prices,” says Hynes. Roy Hill isn’t ramping up as fast as the market expected. Also, BHP and Rio’s recent quarterly reports have shown a decrease in production guidance for over the next 18 months, reducing the risk of further growth in supply.”
As a consequence of the two, Hynes expects prices to remain supported, despite the continued wild movements in futures markets.
“Despite rising speculation in Chinese futures contracts, we are not expecting prices to push back below US$50 a tonne on a sustainable basis.”
Though true that property and infrastructure investment in China improved markedly from February this year, the question many are asking is how long it will last, particularly given concerns about an oversupply of housing stock in smaller Chinese cities that is expected to take years to clear.
In a note released earlier this week, Gerard Burg, NAB’s senior Asia economist, described the recent construction-led, credit-fuelled rebound in the nation’s steel industry as “unsustainable”, suggesting that it threatened to derail necessary reforms to the sector that authorities have been promising for the past six months.
We’ll get a better indication on whether the stimulus-driven construction rebound continued last month, something that helped to underpin commodity price gains including for iron ore, with Chinese fixed asset investment and credit figures for April both scheduled for release.
Business Insider Emails & Alerts
Site highlights each day to your inbox.