Is 2012 the tipping point for China steel?

February 22, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The 2011 outcomes in China’s steel and related industries have ratcheted up the risks faced in China’s and the world’s steel and steel-making raw materials industries in 2012. Q411 steel production in China was particularly weak, down 12 pct from the levels enjoyed in the first 3 quarters of 2011.

Steel elasticity in the quarter was negative, as GDP rose 8 pct while steel consumption fell 11 pct q/q. This raises questions whether the steel production patterns since October, annualising at 625mt to the end of January, are an aberration or a harbinger of much lower than expected steel outcomes in 2012 and beyond.

History cautions about the extrapolation of near-term weakness. Government policy response, seasonal factors, potential restocking and the improving global sentiment can turn Chinese steel outcomes quickly.

The government’s response remains pivotal, and recent re-affirmation of social housing in the government’s 2012 plans is an example. The near-term market conditions may therefore prove to be more positive if Chinese steel production lifts relatively from its current lows. The fact that iron ore prices and steel prices have sustained firm levels over the last quarter despite very low Chinese steel production and record levels of iron ore output cautions one about being too bearish near-term.

Nevertheless, there is an undeniable pattern of slowing steel activity. Crude steel production growth of c9 pct in 2011 follows a decade of 18 pct pa average steel production growth. Apparent crude steel consumption growth was up less than expected at 8.5 pct, following a decade of double-digit growth. As a consequence, the longer-term patterns of steel intensity of use, expressed in terms of steel per unit of GDP, appear to confirm an apparent peak in 2009, after a stunning and unprecedented decade of growth.

The strong correlation between property construction and steel use suggests a sustained property construction slowdown within the oversupplied and overpriced commodity housing is the biggest risk for China steel consumption. UBS China property team estimates that commodity housing construction could potentially fall by 25+ pct to establish a market balance in commodity housing.

Meanwhile, consistent feedback from our UBS China colleagues and clients is that the government will not substantially ease its tight commodity housing policies until Q412 at the earliest. Social housing is expected to compensate for some of the commodity housing loses but it appears will peak in 2012.

Our modelling of steel consumption in conjunction with our China property colleagues who expect a 15 pct decline in commodity housing confirm how critical commodity housing is to China’s steel consumption, we estimate 30+ pct of steel is being consumed in commodity housing. We forecast flat steel consumption in construction to 2015 while non-construction steel growth is expected to be c7 pct pa, much closer to GDP growth.

While recognising the link between Chinese steel exports and price differentials between China and international markets (U.S.-China price difference), our forecasts assumed that net exports will only rise steadily in the next 4 years, from 2.6mt/month to 3.3mt/month with the efficiency objectives of the 12th 5-year plans likely to cap export growth. Therefore, we do not expect any steel production relief through increased exports.

Consequently, we run several scenario analyses that ranges from our ‘mark-to-market’ forecast revisions that see 2012E production at 713mt (13mt below previous) to two other scenarios, one a ‘Flat steel growth in 2012E’ with steel production at 683mt in 2012E (43mt below previous) and the second that tests ‘Steel production falling by 5 pct in 2012E’ to have steel production at 649mt in 2012E (77mt below previous).

The translation of the scenarios into steel and iron ore price outcomes was problematic because of the peculiar structure of these industries and the resulting dynamic pricing ‘feedback-loops’. As China is nearly half of the world’s steel output, it ultimately tends to modulate if not cap global steel prices.

We would expect lower utilisation rates will pressure Chinese steel prices and global prices lower. If the steel price differential between the China and the rest of the world rises beyond the level that covers the Chinese delivery costs to international markets, history suggests China will export more steel, ultimately capping international steel price rises.

Our scenarios suggest that if our worse case conditions prevailed iron ore imports into China could potentially fall by 20 pct and prices by 40 pct. But lower prices of seaborne iron ore is expected to see supply responses. Firstly, the highest cost segment of Chinese iron ore production, that has ‘chased’ the higher iron ore prices by mining lower iron grades could see some production falls. Our reconciliations suggest that the average grade of Chinese iron ore in 2011 was 17 pct iron content, and that over the last five years the national average of iron grades fell from 30+ pct to 20-pct contained iron. In 2011, we estimated that China’s domestic iron ore production contributed a third of total iron units.

The mining and processing of low grade iron ore (20-pct Fe) is inefficient in terms of power, water and waste management and appears to be in conflict with the objectives of the current five-year plan. We expect increasing political pressure could cap and reduce this activity. The waste management alone is staggering; the 1.33bt of iron ore mined in China in 2011 produced 0.33bt of 66 pct Fe concentrate and c1bt of waste that had to be disposed in dams. We estimate that at least a third of China’s domestic iron ore production has cash costs of more than $120/t and would be challenged if iron ore prices fell below that level.

We also expect the consolidated supply of iron ore where the big three overseas mining companies provide more than two thirds of all seaborne iron ore. No other commodity market now exhibits such a high degree of supply-side co-ordination as the seaborne iron ore trade. If the price falls we would expect some moderation in supply.

So we will continue to monitor China’s steel outcomes in coming months after the disrupted data of the last couple of months. If by April, steel production has not rebounded we will have to start thinking of the consequences of a possible unprecedented year-on-year fall in China’s steel production and its implications for global steel and steel-making industries.

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