Citibank remains ice cold on iron ore, despite the recent price recovery

Bill Pugliano/Getty Images

Iron ore prices are likely to come under renewed pressure in the years ahead, but on the back of a rebound in Chinese steel output in recent months, the risks to the short-term are skewed to the upside.

That’s the view of Citibank’s multi asset research team who believe that the scale of this upside “hinges heavily on China’s policy decisions between short-term stimulus and structural reforms”.

When it comes to global iron ore demand, China is as close to being the “market” as one individual nation can get. It absorbed 70% of all seaborne iron ore supply in 2015, making it the single-greatest influence on price movements the world over.

According to Citi, the main sources of demand came from China’s real estate, infrastructure and machinery sectors, accounting for close to two-thirds of total annual demand last year.

Given the composition of demand, and that fact that China is the largest steel producing nation globally, it’s not hard to see which areas investors need to watch when it comes to the demand side of iron ore price equation.

Although Citi, like others, questions the sustainability of the recent rebound in residential construction activity, something that has shocked many analysts given years of unsold housing inventory that already exists in smaller Chinese cities, the bank suggests that the outlook for infrastructure investment poses the greatest upside risks to the iron ore price over the short term.

“The biggest upside to short-term China steel demand is strong infrastructure build-out mapped out by central and provincial governments through aggressive investment plans, including an RMB 4.7 trillion transportation infrastructure fund unveiled in May,” says Citi.

“During the first four months of 2016, nominal Chinese fixed-asset investment (FAI) in infrastructure improved 19.7% YoY compared with a 10.5% growth of overall FAI.

“Strong FAI growth should boost demand for nearly all major types of steel demand including rebar, HRC and wire rod.”

Over the longer term, however, Citi suggests that Chinese steel demand will likely weaken further as fixed asset investment slows, something that along with a protracted shuttering of excess steel making capacity will likely keep steel prices, and its key ingredients, under pressure.

“Stimulus policies on infrastructure and property investment will provide near-term support to demand but will also prolong de-capacity progress. We believe the government will likely take a reactive approach in cutting steel capacity amid falling demand, leaving steel prices fluctuating at low levels,” Citi notes.

It outlines the base case scenario for Chinese steel demand for this year and next below, attaching a 65% probability that this scenario will eventuate.

China steel demand falls 0.3% in 2016 and 0.7% in 2017, as a slowdown of real estate demand growth is offset by strong infrastructure growth. Net exports rise from 100Mt in 2015 to 105Mt in 2016, reflecting weak domestic de-capacity efforts and that Chinese steel mills take the opportunities to benefit from strong export arbitrage. Under the base case, China steel output should remain largely flat in 2016 and 2017.

With global low-cost iron ore seaborne supply likely to growth further in the year ahead, something that will coincide with expected weakness in demand despite the closure of uneconomic producers, Citi remain bearish towards the outlook for prices, predicting that the benchmark 62% price will oscillate between US$38 to $45 a tonne over the next 18 months before settling at around US$40 a tonne out to 2020.

“Citi maintains a bearish view on iron ore and recognises that a structural decline of Chinese steel production and a strong seaborne supply pipeline should point the market towards oversupply. Therefore prices must stay lower for longer to incentivize curtailments by high-cost producers and to rebalance the market.”

Here are the bank’s updated iron ore forecasts, using pricing provided by The Steel Index.

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.