This analyst just made a great point questioning why iron ore is skyrocketing on firmer steel prices

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Iron ore prices are on a tear, jumping to a more than two-year high on Wednesday, leaving the gain over the past 12 months at 115%.

It’s been an amazing run, fueled in part by continued strength in steel prices.

The latest leg higher, something that saw the benchmark iron ore spot price jump by 17% in less than three weeks, has been partially driven by ongoing environmental inspections that have restricted output at some steel mills, further tightening steel supply.

“Chinese public news agencies reported that Hebei has joined the growing list of provinces being investigated over the production of substandard steel, along with Jiangsu, Shandong, Liaoning and Sichuan provinces,” said analysts at Metal Bulletin on Wednesday.

“The speculation that the investigations could cause tighter supply pushed up both futures and spot market prices,” it added.

That, along with elevated costs for coking coal, adding to the appeal of higher grade iron ore which requires less coal for steel production, has helped to lift iron ore prices as a consequence, or so convention goes.

However, Vivek Dhar, an energy and commodities analyst at the Commonwealth Bank, has made an excellent point in a research note released on Thursday, questioning whether reduced steel output should help boost iron ore prices.

“Iron ore climbed above $US80 a tonne as steel prices continued to track higher on views that Chinese authorities will enforce further environmental restrictions on steel output in coming months,” he said.

“Stronger steel prices tend to lead iron ore prices higher as incentives to expand output increase. But that really only works when the lift in steel prices is demand led.

“With the lift in steel prices linked more with future supply cuts, the more prevalent risk is that iron ore demand will fall,” he adds.

If less steel is being produced, there’s less demand for iron ore, essentially.

Dhar says that “this risk should eventually drive iron ore prices lower”.

Whether that eventuates or not, and by what degree, will largely be determined by property construction in China given it accounts for around 40% of total steel demand per annum, along with the actions of Chinese commodity futures traders.

With authorities already taking action to cool property price growth in many major cities, which to lead those in other parts of the country, along with iron ore stockpiles currently sitting near two-year highs, it’s easy to see why many analysts think that the iron ore rally is unlikely to last.

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