Is Vale's Optimism On Chinese Demand Justified?

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Includes: BHP, RIO, VALE
by: Alpha World

Summary

Vale CEO said at a conference recently that the second half will be better in terms of Chinese demand for iron ore than the first half of this year.

Vale CEO also expects steel prices in China to rise as several producers have left the market and this in turn will boost production.

However, there is still significant overcapacity at Chinese still mills.

Latest data has shown that steel output fell in May.

Vale SA (NYSE:VALE), one of the three major iron ore miners in the world, is bullish on China. It was a slowdown in demand from China that coincided with increasing production from majors, leading to a glut in the seaborne iron ore market and a crash in prices. Despite China's struggling construction sector, majors have been ramping up production in the hope of gaining market share. And latest reports from China suggest that the weak iron ore prices have been hurting high-cost local miners. The question though is whether Vale is right in expecting a turnaround as early as this year.

Iron ore prices have rebounded sharply since April on the back of some positive developments, which I discussed here. Vale itself has announced that it will "push to the fullest" production of the highest grade iron ore, which commands a premium. Such a move could help in improving the fundamentals of the seaborne iron ore market; although an inflection point is still some way off. Another positive for iron ore market has been monetary easing in China. The People's Bank of China (PBoC) has announced three rate cuts since November and also reduced the reserve requirement for banks.

The main goal of majors, which includes BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) apart from Vale, has been to drive out high-cost miners and so far they have succeeded. In 2014 alone, 125 million tons of high-cost production from China and non-traditional seaborne suppliers exited the market, according to Australian miner Rio Tinto. According to the China Iron and Steel Association, China now imports over 80% of the iron ore it needs, up from 70% two years ago. According to the Wall Street Journal, China's iron-ore output has fallen around 20% in the past year.

Not only is the cost of digging in China significantly higher, the ore itself is of lower quality. The ore mined in Australia and Brazil has around 60% iron content, compared to 30% in China. A resource tax on iron-ore production has already been reduced to support Chinese miners, however, that is not sufficient. Without higher prices or more support from government, high-cost miners will not be able to sustain. This was also the point made by Vale's CEO Murilo Ferreira at a recent conference.

Speaking at a conference organized by Fundacao Getulio Vargas in Rio de Janeiro, Ferreira said, "Several Chinese producers -- a higher number than people realize -- have already left the business." Ferreira is certainly right about the state of Chinese miners. However, I have some doubts over his outlook for iron ore demand in China in the second half of the year.

Ferreira noted in the conference that the second half of the year will be better for the industry than the first half, driven by a ramp up in Chinese demand for iron ore. Ferreira noted that domestic steel production in China has fallen by around 200 million metric tons and a number of producers have left the market. This will have a positive impact on prices and would boost steel production, which in turn will lead to higher demand for iron ore.

Although Ferreira's bullish comments boosted Vale's shares on Wednesday, which rose more than 5%, his optimism is not justified. There is still a significant supply surplus at China's steel mills. According to Ernst & Young, the level of excess capacity at China's steel mills could be as high as 30%. Michael Elliott, Ernst & Young's Global Mining & Markets leader, told CNBC last month that steel prices will remain low for the next five years.

Indeed, latest data from the National Bureau of Statistics showed that crude steel production in May fell 1.7% on a year-over-year basis as prices fell to record lows.

While China's central bank has announced three rate cuts and other easing measures, it will be sometime before they take hold. The construction sector is still struggling, with new construction starts falling 16% in the first five months of the year. A recovery is expected in the construction sector in the second half of the year, as I have noted in earlier articles (here and here). Once that happens, steel prices will get some support. But it is unlikely to lead to an increase in production as Ferreira expects due to the overcapacity.

Disclosure: The author is long VALE, RIO, BHP.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.