Here's How China's Tougher Environmental Policies Are Transforming Australia's Iron Ore Market

Photo by China Photos / Getty Images.

The prices of higher quality iron ore are holding strong coming into 2015.

It’s a trend which is causing a little confusion in the market given the spot price of the lower grade product, known in the market as fines, fell throughout 2014 as a result of oversupply and tapering Chinese demand.

But Chinese demand for lump iron ore — the higher quality product — is on the up. It’s largely being driven by tighter environmental controls in the region.

In a note today Morgan Stanley said: “Faced with new capacity-limiting regulations, but still determined to meet local crude steel demand, many of Hebei’s steel mills are taking some short-cuts – including buying more lump.”

Purchasing the more concentrated ore means it doesn’t have to be processed as much before it’s put into furnaces which means it’s cheaper to process and slightly kinder to the environment. But producers charge a premium for the ore.

The Morgan Stanley chart below shows the recent growth of the lump iron ore premium. The lump iron ore price is roughly calculated by adding the premium on top of the spot price.

Morgan Stanley analyst Joel Crane said another reason the premium jumped late last year could be the APEC summit in China.

He added increased demand for the higher quality ore could inject more volatility into the iron ore price because higher cost producers with lower quality ore, including Fortescue Metals Group and Atlas Iron are forced to discount their product.

“At times when prices are falling, or when Fortescue gets desperate, they increase that discount… so you can buy more of this for cheaper,” he said.

“You can’t just chuck in Fortescue product, you need to blend it with better product like Vale which is usually around 66% or some of the higher end product BHP and Rio sell.

“Atlas Iron is even worse off than Fortescue because their product is really weak quality wise.”

Since China has become such a major importer, Vale has set up a distribution centre in Malaysia where they ship high quality ore and then sell it directly to Chinese mills. In the past traders would buy a little bit of Vale product, mix it with Fortescue ore, for example, and then sell it as a blended product. Crane said Vale was trying to eliminate that.

Lump is more valuable than fines, historically attracting a 20% to 30% premium. About 70% of the ore exported is fines with the remainder higher grade lump.

“It’s beneficial to premium product producers as opposed to negative for lower quality producers. It probably doesn’t affect them much it’s just better…for producers who trade that sort of product. BHP Rio and Vale, it’s good for them. It’s not necessarily bad to Fortescue and down [meaning the producers smaller than FMG] because it’s just not a market they’re involved in,” Crane said.

Morgan Stanley expects the premium and iron ore prices in general to lift in line with seasonal industry activity which usually occurs between February and May.

“Prices likely to remain depressed amid vast oversupply. However, we think prices return close to US$90/t if high cost supply exits the market,” Morgan Stanley said.

But it’s not all bad for lower quality ore miners.

IG Markets strategist Evan Lucas in his morning call today noted the iron ore price may be about rise.

“Chinese inventories hit an 11-month low on data released from Shanghai, Steelhome shows. Steel mills have begun to restock on the lower pricing, meaning stock piles at Chinese ports have fallen steadily for the past six weeks. At US$71.49 a tonne, it still has plenty of room to move and restocking may bump the price up,” he said.

Overnight iron ore was up 0.9% to $US71.49 a tonne.

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