Even by their usual standards, the moves in iron ore markets in recent days have been wild.
Slammed last week, prices ripped higher on Tuesday, seemingly out of nowhere.
While there’s any number of reasons being cited to explain the sudden and dramatic turnaround, one factor that’s been cited is a research note from Goldman Sachs in which the bank upgraded their view for prices in the year ahead.
Given the level of interest, it’s an opportune time to see exactly what it said.
Here’s a few key snippets from the research note from Hui Shan, Amber Cai, Christian Lelong and Jeffrey Curry, analysts at Goldman Sachs.
On fundamental factors that drove the rally this year
Demand surprised to the upside on the back of the China credit stimulus earlier this year. Our China economics team estimates that, in H1 2016, a total of RMB 14 trillion was injected into the economy, equivalent to 35% of GDP. During the first 10 months of 2016, property sales in China increased 27% yoy, auto sales climbed 14%, and excavator sales jumped 17%.
In addition to higher steel demand, inventory restocking also boosted demand for iron ore. China port inventory increased 20Mt in 2016, reversing the destocking trend in 2015 and resulting in a tighter seaborne market.
Lower than expected iron ore production is another tailwind to iron ore in 2016.
Iron ore’s relationship to coking coal prices
Metallurgical coal prices in China rallied strongly in 2016 as a result of supply-side reforms aimed at cutting excess capacity in the coal industry. Because metallurgical coal is a key ingredient in making steel in China, steel mills had to raise steel prices as production costs rose. In particular, high-grade iron ore, which needs less metallurgical coal in steel production than low-grade iron ore, enjoyed a large premium when met coal became more expensive. Although one would typically expect a limited or even negative impact of higher metallurgical coal prices on iron ore demand, the market appears to be chasing the rally with iron ore prices tracking closely to rising steel prices.
And the more speculative elements behind the move in prices
With ample onshore money supply, low returns on bank deposits, and relatively tight capital controls, Chinese investors seem to be searching for higher yields, from the stock market in 2015 to the property market in 2016. In recent months, the renewed CNY depreciation against the US dollar and the government’s effort in curbing price appreciation in the real estate market may have led to speculation in the commodities market.
The outlook for prices in 2017
We envision a three-step price path in 2017.
In the first step, we expect a near-term correction, which is already underway since iron ore prices reached almost US$80/t post-election, to continue until prices reach US$65/t. During 2017H1, we see supply and demand roughly in balance and expect prices to stay above US$60/t. During 2017H2, however, we expect the supply pressure to begin to build and iron ore prices to fall to US$55/t by year-end.
We revise up our long-term equilibrium price to US$45/t (previously US$35/t).
And the risks to its forecasts
On the macro front, political uncertainties loom large both in the US and in China. While the market priced a large demand boost from infrastructure spending by the Trump administration following the election outcome, it is unclear to what extent protectionist policies may also be pursued which could negatively affect global growth and the demand for capex commodities.
Regarding China, policymakers have been trying to strike a delicate balance between near-term growth and long-term structural reforms. While nearterm growth appears to be winning the upper hand in 2017, the balance may shift in 2018 after the leadership transition.
On the micro front, iron ore port inventory has already risen to above historical average levels and it remains to be seen how much inventory can continue to increase without negatively affecting spot prices.
Additionally, the onshore iron ore futures market has proved to be an easy target for speculation and bullish sentiment due to its backwarded forward curve.
While Goldman has clearly become more optimistic on the outlook for prices, it’s worthwhile noting that its forecasts are all below the current spot price of $74.50 a tonne.
And all of the risks it has cited are to the downside, not the upside.
Given the wild price moves seen in recent weeks have been driven by futures markets, leaving the benchmark spot price up over 70% for the year, Shan, Cai, Lelong and Curry appear confident about one thing in the year ahead.
“If the pattern continues, we would expect the path of iron ore prices in 2017 to be anything but smooth.”
Best of luck to the Australian treasury staff who are formulating the next set of budget forecasts.
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