CBA: There are 'heightening surplus risks' building in iron ore markets

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Thanks to a flurry higher in recent weeks, iron ore prices have enjoyed a solid start to 2016, rallying close to 30%.

After a tough few years, culminating in a price decline of near 80% from the lofty peaks of early 2011, it has been a rare piece of good news, particularly for high-cost, low-grade mines.

It has some optimistic that the lows are over for now. It’ll only be onwards and upwards from here, some forecasters say.

While others are bullish, Vivek Dhar, a mining and energy analyst at the Commonwealth Bank, is not.

In his opinion, a recent anomaly in the iron ore market — a lift in inventories and prices at the same time — has him wary about the outlook for prices in the second half of the year.

“The lift in iron ore inventories together with the lift in iron ore prices is unusual,” he says in a note released on Wednesday.

“Higher iron ore inventories normally tend to put pressure on iron ore prices. The deviation in this relationship over the last month is concerning too in that trade and production data suggest heightening surplus risks in iron ore markets.”

The chart below, supplied by Dhar, shows the past relationship that the benchmark spot iron ore price has had to Chinese port inventories, going back to mid-2012. As it reveals, as inventories tend to lift, the price tends to fall, and vice versus. However, in the first half of 2016, this relationship has broken down with prices and port inventories rising in unison.

Alongside that anomaly, Dhar points to other factors that suggest the risks for prices moving forward are clearly to the downside.

“China’s iron ore imports have lifted by 9.0% y/y from January to May, while crude steel production has slipped 1.4% y/y in the same period,” says Dhar.

“On top of that, there is evidence in May that domestic Chinese iron ore production lifted due to the pick-up in prices.

“All in all, the data points to another downward correction in iron ore prices.”

While he is not calling for iron ore to test the multi-decade low below US$40 a tonne struck in early December last year, he suggests that the current spot price of around US$55 won’t last.

“We expect China’s raw materials consumption to weaken in 2H16, driven by an ongoing retrenchment in China’s property sector later this year,: says Dhar.

“We see prices returning to US$40-45/t (CFR China) in 2H16 as surplus risks mount.

“This surplus also reflects resilient supply from Australia and Brazil as a number of projects ramp up to capacity.”

The benchmark spot price for 62% fines closed Tuesday’s session at US$55.93 a tonne, according to Metal Bulletin, leaving the gain over 2016 at 28.4%.

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