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Why we are short / underweight iron ore

August 2021

By Nick Pashias, Co-Head of Equities and Portfolio Manager of the High Growth Shares Fund and Elite Opportunities strategy, Antares Equities

Nick is responsible for researching stocks in the Metals & Mining and Telco sectors. He has 23 years industry experience and previously consulted on efficiency improvement & process streamlining in the mining industry. Nick holds a Ph.D. in Chemical Engineering and a Master of Applied Finance.

We have been short or underweight iron ore for some time because our research led us to conclude that commodities and iron ore in particular, would come under pressure from the second half of 2021. Many of the factors that have led us to this conclusion are driven by China and include unsustainably high steel production in the first half of this year, slowing credit growth, rising inventories of steel and iron ore and a growing environmental focus. Also relevant is the ramp up in production by Vale. We discuss these factors in more detail in this article.
 

Chinese steel production was unsustainably strong in the first half (1H) of Calendar 2021


Chinese steel production has grown at almost 11% in 1H2021, a growth rate not seen in many years. If this rate of growth was sustained over the full calendar year, steel demand would increase by almost the total amount of steel consumed by the US (or India) in one year.

Figure 1: Chinese monthly steel production

Source: Antares, Bloomberg; August 2021.


Figure 2: Chinese high frequency steel production (year on year growth)

Source: Antares, Bloomberg; August 2021.
 

China’s credit impulse has been slowing for some time and should impact the real economy in the current half of 2021
 

China’s credit impulse (blue line in Figure 3) measures the monthly change of the flow in new credit as a share of GDP. It has been slowing for some time. Historically it has led the performance of the S&P/ASX Metals and Mining Index (green line) by around 6-12 months.

Figure 3: Chinese credit (blue) vs S&P/ASX Metals & Mining Index (green)

Source: Antares, Bloomberg; August 2021.
 

Supply is seasonal: weak in 1H, strong in 2H


Given the wet season in Brazil, iron ore exports accelerate in the second half of the calendar year. For 2021 this provides a mismatch as supply is increasing at a time when demand is weakening.

Figure 4: Vale shipments seasonal split


Source: Vale, Antares Estimates at August 2021.
 

Finished steel and iron ore inventory have been rising


Iron ore inventory has been rising at a time when steel production has been very strong.

Figure 5: Iron ore inventory


Source: Bloomberg, August 2021.
 

Steel production, especially steel produced in a blast furnace (requiring iron ore) will inevitably be curtailed given China’s environmental focus


China has introduced a carbon trading scheme. At this stage steel making is exempt, but our industry contacts suggest that over the next year or two the steel industry will be included. China’s policy seeks to reach peak carbon output by 2030 and become carbon neutral by 2060.

Figure 6: China’s carbon emissions by sector


Source: Peking University, China; 2018.
 

Vale couldn’t possibly produce less iron ore than in 2020


Over the last few years Vale has failed to produce to its capacity and this may also be the case in 2021. However, our focus is the incremental growth that Vale is able to produce each year and we are confident that Vale will deliver additional iron ore tonnes to the market this year and in the years ahead.

Figure 7: Vale iron ore shipments (‘000 tonnes)


Source: Vale, Antares estimates at August 2021.
 

The move to Electric Arc Furnace’s will limit iron ore demand


There are two basic methods to produce steel: one that requires iron ore and one that requires scrap steel. The scrap steel process or Electric Arc Furnace (EAF) path is being increasingly favoured by China given its relatively lower carbon emissions. Although currently only a small percentage of total steel production, EAF’s have gained in popularity over recent years - a trend we believe will continue.

Figure 8: China’s implied EAF Production (‘000 Tonnes)


Source: Vale, Antares estimates at August 2021.

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