1. The small Chinese mills produce the bulk of long steel products, which may have seen a pick-up in demand in recent months from the Chinese stimulus programme. They also expect to see a further pick-up in long steel product demand in the quarters ahead.
2. The price of long products has risen in line with demand, and the small/medium mills are able to capitalise on the higher product price, against the very low spot price of iron ore, to capture a 200 yuan/tonne profit on the production of long products.
3. The traders are buying iron ore because they are betting on a rise in the iron ore price in the quarters ahead. In fact, they made a good call, since iron ore spot prices reached as low as 40% discount from last year's benchmark price early 2009, but are now trading at about 33% discount from last year's benchmark.
4. There is also a rush in April and May for more imports from India, as India will enter its monsoon season from June to September, which typically restricts the loading of vessels on its west coast Goa port.
5. About half of the Chinese iron ore mines have closed down over the past few months, because their cost of production is around US$67-73/tonne and they sell for US$87/tonne, whereas Indian iron ore can be imported at a cfr cost of US$67-68/tonne including freight. Indian ore is higher quality than domestic Chinese ore. Same goes for Australian ore. As a result, Chinese mills' reliance on domestic iron ore has reduced from 35-40% in Jan 09, to just 25% in Apr 09.
Reasons #1-4 are cyclical, where reason #5 is more structural.
Is this sustainable? There are a couple of reasons why BDI is ripe for a pullback.
1. Steel market experts have recently warned that there is a big surplus of long product inventory in China right now. Not to mention a huge surplus of iron ore inventory. Many steel mills in South Korea, Japan, Russia and Ukraine are exporting HRC and CRC into China, to take advantage of the higher domestic Chinese price against low international price. This could exacerbate the oversupply situation, which could lead to lower finished steel prices. If this happens, and iron ore prices continue to appreciate, the 200 yuan/tonne profit margin could narrow or disappear. This could cause the swing producers (small/medium mills) to cut output, leading to lower imports of iron ore.
2. The coming Indian monsoon season.
Will the pullback take BDI below breakeven? We don't think so, because of the Chinese stimulus spending.
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