The Dragon has landed already
Comment of the Day

April 16 2012

Commentary by David Fuller

The Dragon has landed already

My thanks to a subscriber for this interesting report on commodity demand in China, published by Deutsche Bank Markets Research. Here are some bullet points:
But a slowing China, still needs more steel
Those arguing about whether China will have a soft or hard landing are missing the point. It has landed already. In 2007 steel production growth stepped down from the 23% (achieved since 2001) and has been running at 8.9% since then. Despite the step-down, iron ore prices continued upwards. We believe that Chinese steel production will grow so long as GDP growth stays above 3%. Meanwhile, the miners continue to struggle to keep up.

Chinese steel intensity likely to peak in 2018 based on the US and Japan
Steel is a good barometer for an economy's evolution; it is the first commodity to ramp up and the first to peak. Despite the ramp in Chinese steel production so far, we do not expect steel intensity per capita in China to peak until 2018 - anything less than this would leave a developed coastal region and undeveloped inland. A country divided into haves and have nots is demonstrably not tenable for the Chinese Government. A slowing GDP and a diminishing steel to GDP ratio (DB's base case) is still bullish for iron ore.

The market is pricing in a drop to $76/t iron ore - this is too bearish
To justify the current share prices on the listed iron ore producers we need to drop our price forecast to US$76/t from this year into perpetuity. This would render more than half of China's domestic iron ore production loss making and would need ~150Mt of additional imports to replace it. This would be particularly difficult for an export market that has only been able to achieve increases of around 65Mtpa despite the massive price incentives. The iron ore price has significantly more upside than downside risk (which is supported by cost of production in China) and the iron ore producers are being mispriced.

David Fuller's view Subscribers will see a very interesting graph beneath these bullet points showing China's growing demand for steel since 1999 and projected to 1220, with overlays of the growth trajectories for steel in the USA from 1932 to 1953 and Japan from 1955 to 1976.

You will also see Deutsche Bank's list of 8 top picks and featured companies, all of which are given buy ratings. In the order listed and shown on 5-year weekly charts in sterling these are: Rio Tinto, African Minerals, Randgold, Anglo American, Eurasian Natural Resources, Ferrexpo and Vedanta.

Technically, most of these charts look oversold but they are clearly a long way from the self-feeding, market leading uptrends that we have witnessed in many of the consumer-oriented Autonomies since 2009. In this respect, Deutsche Bank's report is a bold contrarian call, although not without justification.

Note also the Cumulative steel consumption (kg) per capital since 1900 for 10 different countries.

With commodities I often feel that supply is the key variable and the report has a very informative section: The Supply will continue to Struggle, commencing on page 16. Here is the opening paragraph which suggests that China's iron ore imports will have to increase:

Despite nearly a decade of increasing demand for seaborne iron ore, the main global suppliers continue to struggle to step up to the demand requirements. The largest increase in demand has been from China, which has increased its annual steel production rate by 96% or 335Mtpa since 2005 which represents 88% of the world's steel production growth over that period. China has had to mine increasingly low grade domestic ore to compensate for the lack of import availability. We calculate that the average domestic iron ore grade has dropped from ~50% to 20% over this period with a doubling of the iron ore produced since the pre GFC levels in 2008! We calculate that there is between 150 and 200Mt of high cost Chinese production that will need to be replaced before the iron ore price can fall below US$100/t.

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