Thunderclouds are on the horizon for iron ore producers as the strain of too much capacity and too little money finally hits China’s steel mills

February 25, 2014 2:11 pm

Storm clouds gather for seaborne iron ore

By Lucy Hornby in Beijing

Thunderclouds are on the horizon for iron ore producers as the strain of too much capacity and too little money finally hits China’s steel mills.

China now accounts for almost half of world steel production. Its mills’ hunger for iron ore, a key steelmaking ingredient, determines the strength of the Australian dollar, the cost of ocean freight, and the profitability of mining in the faraway jungles of South America. Any hint that the Chinese steel boom has peaked sends iron ore prices skittering.

Liquidity problems have started to bite Chinese mills after years of breakneck expansion. Some private mills in Tangshan, home to about a quarter of China’s steel capacity, are empty and silent after owners ran out of cash to pay their workers. Xu Zhongbo, head of Beijing Metal Consulting Ltd, estimates that 40-50m tonnes of long steel capacity have been idled as production costs exceed prices by Rmb100 ($16) per tonne.

“Steel overcapacity probably exceeds our imagination,” Li Xinchuang, a senior official at the China Iron and Steel Association, warned a conference organised by Metal Bulletin in Beijing on Tuesday.

Already, the prospect of slower Chinese steel growth amid the arrival of new supplies from mines in Australia is weighing on prices. On Tuesday, the benchmark 62 per cent iron ore price, as assessed by The Steel Index, fell to a seven-month low of $119 a tonne, taking losses since the start of the year to 13 per cent.

Last week Andrew Mackenzie, the chief executive ofBHP Billiton, said the price of the steelmaking ingredient would decline this year as rising supply moves the seaborne market into surplus.

Still, there are signs that the party isn’t over yet. CISA predicts that a 3.2 per cent rise in steel products output to 715m tonnes would fuel a 6 per cent rise in iron ore imports this year.

That’s partly due to Beijing’s environmentally destructive policy of promoting domestic iron ore mining while restricting the access of small mills to better-quality imports. Even though China’s reported iron ore production has soared, the quality of the ore stripped out of the ground has declined sharply. Average iron content at Chinese mines has dropped from 31.2 per cent in 2003 to 21.5 per cent in 2013.

“This is universal in most Chinese iron ore mines and can only get worse as most mines face closure,” said Pan Guocheng, chief executive of Hanking Group, which owns nine mines in Liaoning province, home to some of China’s richest deposits. He estimates that China’s dependence on iron ore imports will rise to 77 per cent by 2016, from 72 per cent now.

Amid the gloomy outlook, opinions are divided on the rise in iron ore stocks at Chinese ports to historic highs. Traditionally, iron ore inventories at Chinese ports equal six to eight weeks of import demand. By that measure, Chinese port stocks still have room to grow.

Another interpretation is that the rising mountains of ore at Chinese ports reflect the cash crunch at the mills, and are therefore unsustainable. Industry expert Xu attributes the recent rise in port stocks to the decisions made by cash-strapped mills to buy raw materials only as needed.

Some desperate steel mills are using iron ore imports as a crutch to keep cash flowing. Chinese property developers are famous for importing copper, zinc, rubber or palm oil just to get access to letters of credit, which they use like short-term loans to stay solvent long enough to bring projects to market. Some steel mills have now adopted the practice.

Imports could continue to climb as iron ore traders take the place of steel traders in providing credit to mills. Traders affiliated with Chinese companies big enough to secure access to bank loans say they are fronting purchases on behalf of steel mills whose access to credit has been cut off.

Domestic steel traders had kept their suppliers afloat with their own credit lines until defaults last year caused banks to tighten lending to that sector. Last month, CITIC Bank wrote down $852m in bad loans, most of them to steel trading companies in the Yangtze River delta. And rings of steel traders in eastern China are under investigation for exceeding the limits on their personal credit cards in an attempt to stay afloat.

While the door to Chinese credit is closing, the window for overseas money is still open. Some iron ore traders say they are opening letters of credit overseas where interest rates are lower – particularly in Hong Kong or Singapore – to fund cargoes. “I’ve already lost money on the first three Capesize I brought in this year, so I will be even more dependent on foreign financing in future,” said the head of one private steel trading house, referring to ships that carry about 175,000 tonnes of ore.