Steel demand supporting iron ore price but Chinese SOEs could pose danger

The market for iron ore has in decline since 2011 amid an extended commodities crash, but things may be turning the corner for the steel-making commodity.

How strong the recovery will be, however, remains uncertain. The world's biggest iron ore producers have maintained their output guidance for 2016, as China's appetite for the commodity firms, but supply growth is unlikely to return to old highs anytime soon.

On Thursday, Brazilian iron ore giant Vale gave an encouraging outlook in its second-quarter results announcement, noting a rise in global steel production, which it said grew 6.1 percent on-quarter in Q2. In China alone, steel production growth was 9.2 percent in that period.

"Steel demand improved in China, supported by the credit easing started in 2H15," Vale said.

"Investments in the housing sector increased while investments in infrastructure remained stable in 1H16. The higher steel demand boosted prices and encouraged worldwide production."

Brent Lewin | Bloomberg | Getty Images

The world's biggest producer expects higher iron ore supply in the second half of the year, on the back of seasonal factors.

Last week, Vale reported 86.8 million metric tons of production in the second quarter of 2016, just slightly below the 89.3 million ton record it set in Q2 2015.

Vale's assessment came after investment bank Goldman Sachs on Wednesday raised its three- and six-month iron ore price forecast to $50 and $40 a ton respectively, from $45 and $35 a ton, due to low steel inventories and a fall in the Chinese yuan against the dollar.

"The most important channel, in our view, is the market interpretation that CNY depreciation signals upcoming credit easing," wrote Goldman analysts.

Credit easing in China would boost lending and economic activities such construction.

The improved market outlook is a turnaround from December when spot iron ore prices hit all-time lows around $37 a ton. Prices have since rallied on increased building activities in China, the world largest iron ore consumer, and were trading around $59 a ton on Friday.

China said in May it planned to invest 4.7 trillion yuan ($720 billion) on 303 transport infrastructure projects over three years.

Reports from Australian miners Rio Tinto and BHP Billiton also showed production this year largely on track. Rio Tinto said last week that the company was on target to meet production guidance for the full-year 2016, while BHP said it missed its own iron ore guidance narrowly due to the Samarco dam disaster that shut down the Brazilian mine.

Vale has maintained its 2016 output guidance, forecasting output at the lower end of the 340-350 million ton range.

Despite the firm output forecasts, however, iron ore output growth has slowed.

BMI Research said in a note this week that global iron ore production would grow "minimally" from 3,149 million tons in 2016 to 3,275 million tons by 2020 — or just 0.1 percent a year, down significantly from the average growth rate of 4.8 percent from 2011 to 2015 - as lower prices forced high-cost producers to shut.

"On the one hand, supply growth will be primarily driven by Australia and Brazil on the back of expanding output by major miners, such as Rio Tinto, BHP Billiton, Vale and Fortescue Metals Group," the BMI analysts wrote.

"On the other hand, miners in China, which operate on the higher end of the iron ore cost curve, will be forced to cut output due to continued iron ore price weakness."

In June, an annual survey of 50 leading Australian mining executives showed sentiment had finally started to improve, after several years of gloom amid a commodity price slump that saw iron ore prices plunge more than 70 percent from 2011 highs.

According to by Newport Consulting, 43 percent of respondents were upbeat about industry prospects for the year ahead — more than double the 16 percent who gave the same answer a year ago.

It was also the first time in three years that sentiment took an upturn, although some analysts still advocated caution.

A jump in public infrastructure investment led by Chinese state-owned enterprises (SOE) has raised questions about the quality of growth and sustainability of demand, analysts have noted, given concerns about the debt load of SOEs and the sustainability of some of their business in China's new consumption-led economy.

Data showed first-half fixed asset investment grew 9 percent from a year ago, but private sector fixed-asset investment grew just 2.8 percent in same period, down from 3.9 percent growth in the first five months, indicating headwinds in the private sector from slowing exports and macroeconomic jitters.

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