With Chinese inventories ballooning, the price of iron ore is set to pop

Ezra Shaw/Getty Images

Despite a recent tumble, the iron ore price has enjoyed a stellar start to the year.

The price has gained more than 30%, driven higher by an improvement in Chinese steel prices and a pickup in speculative activity in Chinese bulk commodity futures.

While the price generally has an inverse relationship to Chinese port inventories, as the chart below reveals, that has not been the case in recent months.

From the Commonwealth Bank, it shows that despite a pickup in Chinese iron ore inventories — now standing at 92.2 million tonnes as at the end of April — spot prices have surged over the same period.

According to Vivek Dhar, a mining and energy commodities at the CBA, the lift in China’s port stocks “reflects strong growth in low-cost iron ore supply from Australia and Brazil”.

He also notes that “the lift comes despite stronger incentives for steel mills to buy port inventories for their own use as surging steel prices encourage higher production rates”.

Given the reluctance of mills to draw down existing port inventories, coupled with elements of speculative behaviour now clearly evident in Chinese commodity futures trading, Dhar believes the risk of a price correction in the spot iron ore price is growing.

“The disconnect between China’s iron ore port stocks and prices looks to be growing. It raises the risk of a potential correction in iron ore prices in the short term,” says Dhar.

“We expect China’s raw materials consumption to remain weak this year, driven by an ongoing retrenchment in China’s property sector later this year. We see prices returning to US$40-45/t (CFR China) in 2H16 as surplus risks mount.

“This surplus also reflects resilient supply from Australia and Brazil as a number of projects ramp up to capacity.”

Although the vast majority of risks appear to be slanted to the downside, Dhar suggests the key risk to his forecast is “if the recent pick-up in China’s steel sector is maintained”.

While that would be supportive to prices should it eventuate, it will raise serious questions over the government’s desire to push ahead with meaningful economic reforms, particularly given still-acute levels of overcapacity in both China’s steel and property sectors.

Last Friday the spot price for 62% fines fell by 3.25%, or $1.96, to $58.29 a tonne, extending its losses for the week to 12%.

Chinese iron ore futures closed last Friday’s overnight session up more than 3%, suggesting the weakness may reverse on Monday.

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.