Oops, Iron Ore Dips

As I have highlighted a few times, iron ore prices, which are not traded on a daily basis, is a very good indicator of real demand and health of an economy, especially in property and construction. I was led to believe the trend is still firm when BHP and Rio Tinto got 93% year on year hikes for their iron ore a couple of months back. The recent deal signed with Vale caused me to change my views.

The head of China's leading steel company says the Chinese economy and steel industry are both "heading for a downward slide", as hopes fade that China can insulate Australia's resource-dependent economy from the widening global downturn. The comments by Baosteel's chairman, Xu Lejiang, coincide with new evidence that a contraction in Chinese building construction is seriously crimping demand for iron ore. "The economy is heading for a downward slide, so the steel industry is certainly heading for a downward slide," Mr Xu said at a Baosteel conference in Shanghai.

China recently emerged as the engine of the global economy after seven years of uninterrupted, accelerating growth. But severe credit rationing by the Chinese Government, which has helped to quell an inflation break-out, has coincided with the worsening global financial crisis to smash the confidence of Chinese real-estate investors and the building plans of residential construction companies. Residential construction accounts for about one-fifth of Chinese steel demand.

The research house Mysteel said yesterday the Chinese steel industry was in recession. Prices for steel products had fallen 15 to 20 per cent since July. The Tangshan spot market price for imported Indian iron ore has plunged below $US110 per tonne, down from $US195 in early July. Yesterday, the falling Chinese demand for imported iron ore had cut Australia-China bulk freight rates to as low as $US13 per tonne, from as much as $US50 midyear.

Reading the Chinese economy is even more complicated than usual because the Government shut down a large proportion of industrial and mining activity across northern China for the Olympic Games. But property sales have declined steadily since early this year and property developers are struggling to raise finance for new projects and to complete existing ones, while China's export sector has been weak since early this year.

Most seasoned analysts remain confident about China's long-term growth trajectory. But the next few months are likely to be bumpy, particularly for companies and sectors linked to its building industry. Mr Xu said he had no plans to cut production but warned that steel prices were "plummeting". "A very large number of small steel mills are cutting production," he said. For the first time in more than five years, Chinese buyers can purchase spot market Indian iron ore as cheaply as Australian iron ore on long-term contracts, including freight costs.

Some observers believe contract iron ore prices will fall next year, for the first time in seven years. When yearly contracts were made in February at an 86% increase on last year's prices, China's steel producers were flabbergasted but took the price hike. But that wasn't the end of it. Both Rio Tinto and BHP renegotiated their contracts a couple of months back for even higher yearly percentage increase. Has the tide changed?

The latest indicator was a couple of weeks back when steelmakers in China just announced that Vale, the world's largest iron ore producer, wants to raise prices only 13% above the company's 2008 contract prices. The tide has certainly changed. The critical part was that Vale's share price eased significantly following the news - indicating that demand and hike potential were lesser than expected. Chinese steelmakers are now buying their iron ore from Vale, not only at lower prices than Western companies were paying, but also at lower prices than Rio Tinto and BHP Billiton were charging. Very significant indeed.

While I think the mid term outlook for steel and materials prices would be affected on the downside, I do think that Beijing is turning on the tap as I expect a few rapid rate drops in SRR and BLR in the coming months. However, the whole process could take at least 6 months before projects get re-started and things get re-ignited there. Last word, stay out of building materials for the mid term.

p/s photo: Nguyen Thuy Lam