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In my article "Update On The Chinese Residential Real Estate Market," commenter mh001 added an important piece of data that will allow us to further research the impact the residential real estate market can have in the iron ore market. This data consisted of estimates regarding the steel incorporated into typical buildings, drawn from a Chinese story on the subject. Using this and other data, I will try to quantify what impact a reduction in activity in China's (NYSEARCA:FXI) residential construction can thus have on the iron ore market.

Data

For this exercise we'll use the following data:

Assumptions

We'll also use the following assumptions:

  • A theoretical factor of 1.559 to establish the needed iron ore for that production (based on an 62% Fe iron ore grade; some statistics for iron ore production do not account for the different grades - such is the case with Chinese statistics on iron ore production, so we have to calculate the theoretical iron ore that would be needed at a given grade. The factor is as used by Steel.pk for a typical blast furnace for a specific steel grade, other grades might certainly vary);
  • The residential starts will converge toward completions and sales;
  • The residential starts are a good proxy for the demand of steel for residential construction (this isn't entirely solid, given that there might be timing differences during construction, but over time it's a reasonable assumption);

Scenarios

We will produce scenarios for several levels of consumption of steel ($60, $70, $80 per m2, based on the article mh001 pointed out, "Investigation and Analysis of new trend in Steel Usage in China" and for several levels of residential demand, namely drops of 10%, 15%, 20%, 25%, 30%. Presently residential sales are falling at a 15.5% clip (first quarter of 2012). These drops in end demand imply much larger falls in terms of starts, because end demand is running much lower than starts right now. Starts were falling at a 5.2% rate in the first quarter of 2012, but there's no doubt this drop will accelerate a lot. Using our assumptions for end demand, we'll model drops of 40%, 44%, 47%, 50% and 53%, respectively (some rounding).

Outcome

Given the data, assumptions and scenarios stated, this is what we get.

First, we can calculate how much steel residential construction seems to be taking, and how that compares with overall Chinese steel production.

(Click to enlarge)

Then, we might see how much does that steel represent in terms of iron ore, and how it compares with imports.

(Click to enlarge)

Given all the assumptions, we can also calculate the drop in demand of iron ore that might result from the estimated drop in end demand, and resulting drop in starts. Keep in mind, here, that the estimated drop in end demand is light and already happening in the market, the starts are still lagging but will inevitably drop to fit demand.

(Click to enlarge)

And finally, how much does this drop in iron ore demand represents in terms of the iron ore imports presently occurring.

(Click to enlarge)

Conclusion

What this exercise shows is that if the drop in Chinese residential construction happens within the time frame of 1-2 years, then the resulting drop in iron ore demand is enough to negate the present growth rate in terms of import volumes, especially since this exercise does not take into account further impacts on commercial real estate, which usually lags residential, as well as infrastructure made to serve both kinds of real estate. Also, the article does not cover the stagnation in the auto market, and the severe reduction in shipbuilding.

So the basic thesis remains that due to reduced residential construction activity, the iron ore market will face stagnation in demand versus expanding capacity (in China and abroad), and will thus suffer significant price declines, with negative margin consequences for iron ore suppliers: Rio Tinto (NYSE:RIO) - around 45% of RIO's 2011 revenues and 70% of its EBITDA comes from iron ore; VALE S.A. (NYSE:VALE) - around 72.5% of VALE's 2011 revenues came from iron ore; BHP Billiton (NYSE:BHP) - almost 50% of BHP's EBIT is from iron ore at a 65% EBIT margin.

Source: The Chinese Residential Real Estate Impact On Iron Ore