Andy Home@ (Repeats with no change. The opinions expressed here are those of the author, a columnist for Reuters)
* China iron ore price and stocks: http://tmsnrt.rs/2hBCmMj
LONDON, Aug 7 (Reuters) - Chinese steel and iron ore prices continue to rise in lock-step.
In Shanghai today the most active steel rebar contract went limit-up, surging 7 percent to 4,013 yuan per ($597) per tonne, its highest level since April 2013.
Where Shanghai steel leads, Dalian iron ore follows.
The most-traded contract on the Dalian Commodity Exchange jumped as much as 7.3 percent to 587.50 yuan per tonne at one stage, its highest level since March 21.
And where Dalian leads, the rest of the iron ore world follows. On the Singapore Exchange the cash contract has just punched up through the $77-per tonne level, also for the first time since March.
There is much speculative froth in this mix. Market open interest on both Shanghai steel and Dalian iron ore hit record highs last month and is still at historically elevated levels.
However, this is not just irrational exuberance.
There are good reasons for steel's extended rally and as long as steel prices generate high margins for China's steel mills, there will be a knock-on effect on iron ore pricing.
That said, the 140-million tonne elephant in the room for iron ore pricing is the amount of the stuff now sitting in Chinese ports.
The market is ignoring it right now but for how long it can continue doing so is a moot question.
STEEL - WINTER IS COMING
China's steel producers are still riding the crest of the most recent government stimulus wave.
Beijing's 2016 package was channelled down the well-grooved paths of infrastructure and property, both key usage drivers for the steel sector.
The tail winds are still gusting.
Chinese steel production increased by 4.6 percent in the first half of this year, the fastest rate of growth since 2013.
Yet exports of steel products slumped by 28 percent over the same period.
Healthy demand, reinforced by supply chain restocking, explains the discrepancy.
Most analysts expect the stimulus effect to fade over the second half of this year but now the Chinese steel market has something new to worry about, this time on the supply side.
Winter is fast approaching and this year it will bring with it mass steel capacity closures in the regions around Beijing.
The government has mandated capacity cuts across a swath of industries, including steel, to improve air quality in and around the capital city.
The winter cuts are separate from ongoing official campaigns to close "illegal" and polluting capacity but may have as significant an impact on the domestic supply chain.
Certainly, the collective realisation that the winter heating season is only three months away seems to be feeding into the current steel restocking cycle.
Graphic on Dalian iron ore price and port inventories:
IRON ORE - A FRAGMENTED MARKET
The strength of Chinese steel demand and output has surprised on the upside this year and it continues to surprise.
And what's good for steel is good for iron ore demand, or at least has helped mitigate oversupply.
Not fully, however, because there are currently 139.15 million tonnes of iron ore sitting at China's main ports, according to local news provider Steel Home.
That's just off the June peak of 141.45 million tonnes and dwarfs anything seen before.
The iron ore price has decoupled itself from this growing inventory mountain because of the widely-held perception that steel mills are buying all the higher-quality ore and leaving lower-quality material to pile up at port side.
The logic is that with high steel prices and therefore high margins, China's mills can afford to buy the better-grade material which allows for improved efficiency and lower pollution.
No-one knows exactly the composition of all that iron ore inventory but analysts at Renaissance Capital, for example, suggest two-thirds of it may be lower-grade, higher-impurity material. ("Metals and Mining: Incorporating higher iron ore prices", Aug. 7, 2017)
Certainly, there is evidence of a widening price discount for lower-grade material.
Australian producer Atlas Iron, for example, noted in its second-quarter report that "discounts for lower grade products continued to increase over the June 2017 quarter", depressing the company's realised price.
Vedanta Resources, which mines iron ore in the Indian states of Goa and Karnataka, concurs in its latest quarterly operational update.
"Sales in Goa were lower than production due to the low pricing environment and widening of discount for our circa 56-percent grade as compared to the benchmark price of 62-percent iron grade."
Vedanta is sitting on 2.4 million tonnes of iron ore, which it aims to release to the market after further beneficiation and blending with higher-grade material.
Which suggests that the inventory of lower-grade iron ore is building all the way up the supply chain to the producer level.
PRICE UP, STOCKS UP?
For now, iron ore bulls, of which there are apparently many in Dalian, are unconcerned about rising stocks.
Trading iron ore and steel has become a two-step dance for Chinese speculators.
As long as steel prices rise, it looks like iron ore prices will follow. Actually, just about every industrial metal is taking its cue from the Shanghai steel market right now.
But the combination of rising price and rising inventory is rarely a happy one for commodity markets in the long term.
Particularly when higher price incentivises marginal production as seems to be the current case for iron ore.
Not only does that boost outright supply but it adds specifically to the mountain of lower-grade material which is currently without a home.
It's hard right now to see what's going to break the virtuous steel-iron ore bull circle.
Both markets are on a roll and feeding off each other's intensity.
But the sheer size of the stockpile that is accumulating at China's ports should give pause for thought that when the bull momentum fades, there are going to be 140 million reasons why the inevitable correction has the potential to turn very ugly. ($1 = 6.7241 Chinese yuan) (Editing by David Evans)