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Are Iron Ore Prices Headed for a Sharper Decline?

By Varun Chandan, Arora – Feb 24, 2014 at 11:31AM

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Iron ore prices could fall sharply if China's trade-financing deals backed by iron ore turn sour.

While the likes of Rio Tinto (RIO -0.62%), BHP Billiton (BHP -0.60%), and Vale SA (VALE) benefited from higher iron ore prices last year, seaborne iron ore is expected to see a surplus in 2014. Expectations of a surplus, which were acknowledged by both Rio and BHP Billiton when they released their financial results recently, had dragged iron ore prices lower. However, prices bounced back sharply this week from a seven-month low as Chinese imports broke records.

The key questions are: What is driving record imports given the fact that steel output in China has slowed down? Can iron ore prices can find support at around $120 a ton, or are they headed for a sharp decline?

Rebound in iron ore prices
Iron ore was among the few commodities that rose last year. However, the outlook for iron ore prices at the start of the year was bearish due to an anticipated surplus in the seaborne iron ore market. Both Rio and BHP Billiton acknowledged the iron ore surplus forecast when they reported their financial results over the past week. According to Mike Henry, head of marketing at BHP Billiton, seaborne supply is expected to rise by more than 100 million tons, even as global demand is expected to go up by 60 million tons. The expected surplus, coupled with a slowdown in demand from China, pushed prices to a seven-month low last week.

However, iron ore prices staged a recovery this week, driven by strong demand from China. Earlier in the week, benchmark iron ore prices jumped to more than $124.40 a ton. Prices rose as steelmakers in China, which consumes two-thirds of global seaborne iron ore, imported a record 86.8 million tons in January, up 18% from the previous month. But given the slowdown in the Chinese economy, the surge in imports is hard to explain.

The real reason behind the surge in iron ore imports
While there was a surge in imports last month, iron ore stockpiles at Chinese ports also rose to a new record. Bloomberg, citing data from Shanghai Steelhome Information Technology, reported earlier in the week that inventories at Chinese ports were 100.2 million tons last week. Apparently Chinese steel mills and traders have been buying more iron ore to use as collateral to secure loans.

This explains why Chinese imports are growing even though a slowdown in the economy has hurt demand for steel, which is used in construction activity. Earlier this week, the People's Bank of China, China's central bank, issued forward bond-repurchase agreements in order to drain cash from the market. The move came after surprisingly stronger credit in January. The PBOC's move highlights the fact that authorities in China are determined to stunt credit growth as they look to shift from investment-led growth to consumption-led growth.

Speaking to Bloomberg, Gao Bo, chief iron ore analyst at Mysteel.com, said that steel mills in China are finding it difficult to obtain funding. According to Bo, much of the imported iron ore is being used as collateral for trade-financing deals.

An official with a state-run iron ore trading firm in China told Reuters this week that steel mills are turning to state-owned enterprises for funding by keeping iron ore as collateral. The state-owned companies can obtain loans even in the present environment, and they are lending to steel mills at higher rates than bank rates. Once the mills repay their debts, they receive their iron ore shipments back, the official told Reuters.

These trade-financing deals explain the recent surge in imports. While they helped push prices higher this week, they could have a negative impact on prices in the future.

Iron ore prices could drop sharply
The Chinese economy has been slowing down, as the data released earlier this week showed. So far, Chinese authorities have not shown any intent to provide stimulus like they did during the financial crisis of 2009. This indicates that authorities are looking for a shift from investment-led to consumption-led growth. While the rebalancing will benefit the Chinese economy in the long term, it will be painful in the near term.

Given the slowdown in the Chinese economy, coupled with the efforts to slow down credit growth, construction activity is expected to be weak, which would curb demand for steel. This would hurt iron ore prices.

Weakness in iron ore prices could trigger margin calls from state-owned companies that have lent to steel mills. But if the slowdown in the Chinese economy persists and demand for steel remains lackluster, steel mills might find it difficult to meet those margin calls. This could force the lenders to start dumping iron ore into the market, which would push prices down sharply. Add to this the expected increase in supply from the likes of BHP Billiton and Rio, and the outlook for iron ore prices looks even more bearish than it did at the beginning of the year.
 

Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

BHP Group Ltd. Stock Quote
BHP Group Ltd.
BHP
$59.68 (-0.60%) $0.36
Rio Tinto Group Stock Quote
Rio Tinto Group
RIO
$65.73 (-0.62%) $0.41
Vale S.A. Stock Quote
Vale S.A.
VALE
$15.12 (%)

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