The Great Rebalancing of China’s Steel Market

As China’s economy continues its weak start to 2014, the metals industry has been bearing the brunt of the correction.  Iron ore prices hit multi-year lows in March, although they have since staged a rebound helped, in part, by a new mini-stimulus announced by Beijing.

Despite this, it is becoming clear that China’s role as the major driver of global demand is not as entrenched as it once was. China’s slowdown is not just cyclical but also reflects a major policy shift.  Beijing is now determined to rebalance its economy from fixed-asset driven, heavy industry to one driven by consumption, as well as tackle worsening pollution.

The size of China’s steel industry – which last year provided half of the world’s total steel output – means this will inevitably impact global markets and the related supply chain. The Word Steel Association (WSA)  believes global steel demand will slow this year due to a halving of the growth rate in China.

That puts Chinese demand increasing just 3 percent in 2014 to 721m tonnes, down from the 6.1 percent recorded last year. In 2015, Chinese demand growth is expected to slow further to 2.7 percent.

China’s steel reform appears to be taking a three-pronged approach – cutting capacity, shutting down polluting plants, and upgrading the steel industry to be cleaner and more efficient.

On one level, a slowdown appears inevitable as the industry works its way through excess capacity built-up in recent boom years.

This time, however, the political pressure exists to follow through. Speaking at the recent National People Congress, Chinese premier Li Keqiang promised there would be forced closure of plants, cutting production of 27 million tonnes of steel in the next year alone as well as 42 million tonnes of cement.

 

Dealing With Overcapacity

With estimates of overcapacity running at anything from 100 to 200 million tonnes, more cuts look to be certain in the future. Earlier government targets to restructure the steel industry envisioned taking out some 80 million tons of capacity before 2018.  Some analysts say authorities will be more aggressive. Brokerage Société Générale, however, believes that 130 million tonnes will be earmarked for closure by 2017 or 35 percent of global overcapacity.

On the ground, firms have been responding. New Wuan Iron and Steel Group, the biggest private steel firm in China’s largest steel-producing province Heibei, is cutting 8 million tons of capacity by 2017 – or more than 50 percent of its 2013 output.

But steel reform is more than just cutting capacity as authorities appear equally determined to also modernize the industry.  This was highlighted by comments by premier Li that Beijing’s smog was nature’s “red light” against inefficient and blind production.

To this end, China is also constructing more efficient new mills, many of which will be located in areas less likely to suffer pollution.  In addition, China’s 12th Five-Year Plan emphasized merger and acquisition activity with a goal of creating larger, more efficient steel companies.

New, modern mills are also needed as going forward China’s steel demand shifts towards more high-end steel products.

Traditionally infrastructure and property have been dominant, accounting for over 50 percent of steel usage. This is likely to change due to the emphasis on building more nuclear power plants, wind farms and hydropower facilities as part of the last Five Year Plan being a green energy initiative.  This will be a key driver of demand for high-end steel, where there is a need for heavy plates and high-strength stainless steel.

These new plants also support environmental goals as they are typically relocated to coastal areas away from regions that are suffering from pollution.  Such locations also help cut logistic costs by allowing cheaper seaborne transport to supply raw materials.

These changes have also been acknowledged in the industry.  Earlier this year, Rio Tinto’s CEO, Sam Walsh, commented that the upgrade of China’s steel mills will see a shift in demand to higher quality iron-ore. This high quality ore will need to be imported as lower grade ore is typically found in China.   These more nuanced industry developments  mean we should not be surprised to  see more two-way volatility in the iron ore spot price.  The iron ore spot price has already dropped 27 percent this year, sinking below $100 (U.S.) for the first time since 2012 on May 20. This means more imports are going to China and India, and is bad news for major iron ore producers like Rio Tinto and BHP Billiton. Both companies stand to lose billions on even a $10 drop in the price of iron ore.

The volatility in the iron ore market can be seen in the steadily increasing desire by firms to hedge their risk using CME Group’s iron ore futures contract. Since 2010, open interest in the iron ore 62 percent Fe, CFR China Futures has gone from about 20 to over 5,000 today.

CME Group Iron Ore 62% Fe, CFR China Futures

 

Meanwhile, for the wider steel market, the removal of Chinese capacity could have positive implications for pricing and profitability.  Some analysts expect this will be positive for U.S. prices, allowing them to remain anchored at current high levels in the coming months.  The WSA forecasts U.S. steel demand will make a strong recovery this year, growing at 4 percent, as construction and industrial activity pick-up.

Elsewhere, stronger demand in developed markets will help to offset some of the Chinese weakness says the WSA. And for the first time since 2006, growth rates for Chinese steel consumption will drop below the rest of the world.

Joseph Kim is the executive director of metals products at CME Group.

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