'AIR POCKET': Iron ore prices are about to hit severe turbulence

Yuli Seperi/Getty ImagesIron ore prices in Q3, according to RBC Capital Markets.
  • Iron ore prices have been grinding higher in July, moving back to the middle of the trading range they’ve been stuck in since late March.
  • RBC Capital Markets doesn’t expect it will stay that way, forecasting a nasty “air pocket” for prices is coming.
  • It says this will mark the last “bad phase for the iron ore market as it exits the spending binge of the early 2010s”.

Iron ore prices have been pushing higher recently.

According to Metal Bulletin, the spot price for benchmark 62% fines rose to $66.03 a tonne on Wednesday, leaving it at the highest level since June 19.

It now sits comfortably in the trading range it’s been stuck in since late March.

RBC Capital Markets doesn’t expect it will stay there for long.

“The Chinese economy has stayed resilient through the first months of 2018, but the combination of an expected cyclical slowdown, increasingly challenging monetary conditions and increasing risks of tariffs to the wider economy points to a slowdown in Chinese steel demand in the second half of the year,” says Tyler Broda and Barbora Baluskova, analysts at RBC Capital Markets.

“We see a near-term destocking cycle placing further pressure on iron ore prices as likely in the near term.

“This is also likely to squeeze the premiums for grades that have built up for structural reasons over the past two years.”

So forget prices grinding higher in the months ahead, or the premium being enjoyed by high grade ore on the back of elevated steel mill margins and a push to improve air quality to last.

Instead, softening steel demand will bite.

“As China comes off its previous stimulus push, the key infrastructure sector — around 23% of steel consumption — is likely to see an acceleration of the year-on-year decline in spending, even with the recently announced measures,” Broda and Baluskova say.

“We also expect the strength in the property sector — around 35% of steel consumption — seen thus far in 2018 to fade as the impact from mortgage curbs and policy changes to property financing cause ahead of trend investment to slow here as well.

“We reduce our China steel demand growth forecast to -2.7% from -1.6% previously which suggests a very weak second half for steel production.”

So how far will iron ore prices fall?

Broda and Baluskova suggest it will be short and sharp, describing it as an “air pocket”.

“We move our Q3 forecast for 62% Fe Iron ore China to $48 a tonne, followed by $53 a tonne in Q4, before recovering to the low-to-mid $60’s in 2019,” they say.

“In this lower demand environment, we expect that premiums for higher grade material will fall to $15 a tonne for 65-62% by the end of the year, down from the current $33 a tonne level.”

Nor do they expect lower grade ore to perform well in such an environment, something that has been seen in the past when steel mill margins have fallen.

“Although low grade material should remain lower on an absolute basis at a similar $15 a tonne versus spot, the spread is likely to contract in percentage terms,” they say.

However, the duo say that this should not be read as a positive for low grade material given net dollar-to-tonnage margins are likely to be even thinner.

So it could get nasty in the short-term, seeing all grades fall into a bear market.

However, RBC is more optimistic about the longer-term outlook for prices.

“This is likely to be the last ‘bad’ phase for the iron ore market as it exits the spending binge of the early 2010s,” say Broda and Baluskova.

“Although we do expect economic conditions to be weak in the near-term, over the medium-term, Chinese supply side reforms have created an environment where it will be difficult for [steel mill] utilisation rates to fall much below 80%.

“This should lead to a period of strength for iron ore and very likely increase premiums for grade, quality and pellets.”

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