--Clyde Russell is a Reuters columnist. The views
expressed are his own.--
By Clyde Russell
LAUNCESTON, Australia, July 1 (Reuters) - Iron ore prices
rose the most in 10 months last week, but hopes that this marks
the start of a new bullish phase are likely to be dashed.
Spot Asian iron ore <.IO62-CNI=SI> ended last week at $94.90
a tonne, a gain of 3 percent from the prior week, with prices
bolstered by an improvement in the outlook for manufacturing in
China following the June HSBC flash Purchasing Managers' Index
showing expansion for the first time in six months.
Iron ore prices are still down 30 percent from the $134.20 a
tonne at the end of 2013, but they have recovered since briefly
dropping to a 21-month low of $89 on June 16.
The bullish case for a recovery is largely based on
expectations that Chinese domestic production will drop as
high-cost mines are forced to close on unsustainable losses.
The loss of domestic output will open the door to increased
imports, thus absorbing the extra supply being brought online by
the major mining houses.
This view is bolstered by the improving outlook for steel
demand on the back of faster investment in railway and other
infrastructure spending as the authorities undertake what's been
characterized by several analysts as a "mini-stimulus" to ensure
economic growth remains above 7 percent per annum.
It does appear that Chinese iron ore mines are closing, with
industry website mining.com reporting on June 30 that 20 to 30
percent of domestic mines have been idled, citing the China
Metallurgical Mining Enterprise Association.
Domestic output accounted for about 30 percent of last
year's iron ore demand in the world's largest consumer of the
steelmaking ingredient, equivalent to about 350 million tonnes
of 62 percent iron ore, the global benchmark.
According to a Morgan Stanley research report on June 12,
about 46 percent of this is produced at state-owned mines and
the rest at private operations.
The weighted average cost of state-owned mines is $82 a
tonne and about $101 a tonne for the private companies, Morgan
State-owned mines are likely to continue producing even as
prices fall, given they are more focused on jobs than profits
and many are integrated with steel mills, the report said.
However, private mines will idle some output, with Morgan
Stanley estimating 64 million tonnes of 62 percent iron ore
equivalent could leave the market in 2014.
But this still won't be enough to offset increases in
supply, with the report saying an extra 111 million tonnes will
be added this year to seaborne supplies by the big four global
miners, Vale, Rio Tinto, BHP Billiton
and Fortescue Metals.
Another point worth noting is that if private mines in China
have a weighted average cost of about $101 a tonne, this
suggests they will return to full production if the price rises
significantly above that level.
This implies that the spot price should remained anchored
around this level for the medium term, as a fall below knocks
out some Chinese output but a rise above brings it back.
INVENTORIES, FUTURES CURVE CONTANGO
Another factor cited by those expecting iron ore prices to
rally is reports of low inventories held by steel mills, meaning
they will have to enter the market to replenish stocks.
The flip side to this is high inventories at Chinese ports.
While these did decline to end last week at 112.65 million
tonnes, this was from the prior week's record 113.65 million,
and it will take some time before inventories return to more
normal levels of around 80 million tonnes.
Another positive price factor being currently cited is the
switch to contango from backwardation in the Dalian Commodity
Exchange iron ore futures curve <0#DCIO:>.
The second-month contract was at 676 yuan ($109.04) a tonne
in early trade on Tuesday, while the six-month was at 690 yuan,
a premium of 2 percent. A month ago the six-month futures was at
a discount of 4.9 percent to the second-month.
The switch to contango does support the view that prices are
unlikely to fall much further, but whether the curve has yet
steepened enough to point to a sustained rally is doubtful.
What the short- to medium-term outlook for iron ore comes
down to is this: will enough Chinese domestic output leave the
market to absorb additional global seaborne supply?
So far, it doesn't seem that much Chinese output has
actually been shut in, with official data actually pointing to
an increase in the first five months of the year.
Iron ore output was 131.943 million tonnes in May, up 12.7
percent from April, taking the year to date output to 568.48
million tonnes, a gain of 10.7 percent.
For the bullish case on Chinese domestic mine shutdowns to
be valid, the data for the next few months will have to show
declining amounts of iron ore being mined.
On the bearish side, it seems clear that the low-cost big
four miners will continue to produce as much as they can while
seeking to lower costs.
This confirms the view that the seaborne market is moving to
a structural surplus, a position reinforced by reports that both
Australian miners and Brazil's Vale are offering discounts to
There are merits to both bullish and bearish views on iron
ore prices, but the balance of risks seems more in favor of
rallies being selling opportunities, given the supply overhang
that now exists.
(Editing by Muralikumar Anantharaman)