Iron ore prices entered the New Year at the highest level in almost a decade, as the supply squeeze due to slower Brazilian exports combined with strong demand from China has created the perfect storm for the steelmaking material. Still, high input costs don’t bode well for steel mills and combined with very also high coking coal prices, another important ingredient for steel mills, margins remain under pressure. Or are they?
If one looks strictly at the headline profit margin as constructed by what the average steel mill needs in order to produce one tonne of steel, margins have been under pressure for quite some time now. As the chart below shows, following the very strong levels of 2018, headline generic steel margins in China have gradually decreased and now stand close to breakeven levels:
China Generic Steel Margin, Yuan/tonne
And yet, steel production in 2020 should reach a new record in China and should end up more than 5% higher compared to 2019. In addition, steel inventories remain high on a historical basis (last print was ~9% above last year’s level). All the above make little sense, as profitability seems under pressure, yet steel mills are producing as much as they can in a market that seems flooded with steel.
Macquarie, through their survey, is actually providing a different picture in terms of how profitable steel mills might be. And such a qualitative survey might lay out more answers than the plain generic calculation based solely on futures prices and pre-set quantity formulas. As the chart below shows, China’s steel mills indicate that their operations are quite profitable, as steel prices remain firm and are expected to remain that way for the foreseeable future.
It is as if in the last few months, steel mills seem to divert away from the generic stele margin and actually generate profits, something that is at odds versus history. After all, prices are quite transparent in the industry, at least on a peer unit basis calculations.
Then again, maybe the fact that utilization is quite high has something to do with profitability. Macquarie demonstrates such a trend in the chart below, as utilization in the industry is at record high levels for this time of the year. The difference between the two charts has to do with absolute profitability versus how profitable a steel mill is, so utilization might actually be the missing link between per unit profitability and overall profitability on the steel mill level.
Furthermore, calls for a reduction in steel production by the Chinese authorities could provide an additional boost to steel prices while at the same time dampen the demand for iron ore and coking coal in the process leading to lower input costs.
As Bloomberg recently reported, China has been attempting to cool down the hot iron ore market for 2021:
The recent speculation-driven surge in the value of iron ore is unsustainable and the trend will be reversed when the market settles, a senior executive at China’s top industry body said.
“Iron ore prices will be in a downward trend as the market digests and materializes price speculation,” Luo Tiejun, a vice chairman of China Iron and Steel Association, said at Mysteel Global’s annual conference in Shanghai on Saturday, according to a transcript of his address. He made the comments when outlining the outlook for next year.
Elevated prices of iron ore and coking coal will drive the price of steel and “greatly” limit mills’ profits, Luo said.
In addition, expectations about steel production growth in 2021 are slowly coming down, and officials are looking for actual declines in steel production, something that could support high steel prices and stronger margins for the foreseeable future.
China's ministry of industry and information technology (MIIT) said the country's steel industry must reduce its crude steel output in 2021, as part of low-carbon initiatives under the country 14th five-year economic plan for 2021-25.
China's 1bn t/yr steel sector, as an energy-intensive industry, "must resolutely" reduce steel output to ensure a year-on-year decline, MIIT minister of industry and information technology Xiao Yaqing said during a 28-29 December work conference, according to state-owned media Xinhua. MIIT next year will promote low-carbon initiatives and green projects, increase efforts to reduce steel output and issue new rules for steel sector capacity replacements.
"The government will probably increase steel production restrictions to reduce the crude steel output next year, which may affect the iron ore blending ratios in the blast furnaces," a Beijing iron ore trader said.
Although such a trend is not supportive for growth in iron ore trading, it is unlikely that any reduction will be material enough to impact dry bulk freight. A profitable industry will find ways to import more iron ore in order to further increase profits, and any constraints in capacity will most likely affect domestic iron ore production which actually is the least environmental-friendly material in the overall mix.
Very few people foresaw 2020 to be a record year for Chinese steel production, especially in the middle of a pandemic. China’s steel industry currently looks healthy and in a great position to capitalize on the infrastructure growth that China and the rest of the world will most likely experience in the year ahead. Longer term, there are a lot of valid concerns about such a polluting, old technology industry, but at the end of the day someone has to provide the materials to built and modernize the global infrastructure and China remains in the forefront of such an effort.