Commodities in the Year 2012 – Iron Ore

Commodities in the Year 2012 – Iron Ore

 We have kept our iron ore price forecasts unchanged from last month’s update (“Bulk Commodities – No short term recovery in Iron Ore prices”). We remain
convinced Chinese steel mills are unlikely to restock in the short term, keeping gains in iron ore prices muted. In 2012 we are assuming a relatively low growth rate in
steel output of only 2.5%; but we remain mindful that any further deterioration in the macro environment could result in this being even lower. If so, iron ore prices
could struggle to move higher from current levels.
 Major steel mills are still cutting capacity; which has shown up in the latest steel production figures issued by China’s CISA showing that daily production in early
November was 1.66Mt per day, equivalent to ~607Mtpy. Plus with inventories at relatively healthy levels in China, we can’t see why Chinese steel producers would
come back into the market aggressively this year.
 With an early Chinese New Year (23-Jan), it’s conceivable that steel mills could shut up shop and not return until mid-February. Therefore we don’t expect to see the
typical end of year restocking that is normally the case. But with the Chinese government indicating last week its willingness to stabilize the economy (by cutting the
RRR by 50bps), we expect the steel industry to be a little bit more comfortable in reinvigorating capacity once it does return. This should result in a huge surge in
steel output in 2Q’12, and thus pushing iron ore prices significantly higher. As such, we reiterate our 6-12m price target of $165/t.
 Projects continue to be delayed due to a combination of high capital costs, regulatory issues and construction delays. As a result, our expected surplus in 2014 has
been significantly reduced to only 14mt (down from 30Mt previously). The previously forecast surplus in subsequent years also been reduced.
 We believe rising costs and the recovery of freight rates over the longer term to be supportive of iron ore prices. With capital intensity as high as $180/t, an iron ore
price over $85/t FOB is required to produce an IRR of 15%. This should keep prices well supported at current levels.

Iron Ore Supply and Demand Forecasts

 In China, the inherent imbalances of China’s export and infrastructure-led growth
model are causing increasing risks of a harsher landing. For steel and iron ore
markets in particular, the weak supervision of the state-owned banking system at
the provincial/municipal level may be incubating bad loans in the capital market
system, serving as a potential trigger for a “sudden stop”, in our view.
 In the meantime, we also suspect that Chinese steel mills might be exaggerating
the extent of the steel market weakness in an attempt to lower input costs as
steel prices rollover. As such, we would expect Chinese steel companies to
pullback on any unnecessary iron ore purchases while prices are falling, in the
hope that they can buy at a lower price in the future. This could take at least a
quarter to wash through before they commence any restocking.
 Our base case remains that underlying demand in China stays robust and that
over the next 3-6 months we would expect to see a bounce back in prices once
macro economic issues stabilise. But we think it’s unlikely that prices will stage
any sort of sustainable rally in 1Q’12.