The transition of China’s economy from a largely investment driven to consumption driven is underway. Production of steel in China in 2013 grew at a heady 9.3% to virtually match output from the rest of the world combined. China consumes almost half of the world’s steel. This is outsized relative to other commodities and additional strong growth from this high base will be challenging. Pushing the fixed-asset investment model further, risks future economic shocks. China’s economy consumes more steel per unit of gross domestic product than anywhere else.
In 2014, the rate of growth in steel production has slowed to 4.3% in the year to date. We view this as healthy and a sign of the ongoing shift in economic focus towards consumption and services. The building of iron ore stocks at China’s ports is an inevitable by-product of slowing demand growth.
At the same time we expect supply to do a better job satisfying the slowing demand of growth. In the near term, high and rising iron ore stockpiles scare the market, however, the most likely scenario is that the iron ore price will go through periods of volatility around a declining trend.
For the high quality, low cost producers such as BHP Billiton and Rio Tinto healthy margins will continue and periodic sell-offs, fuelled by sharp declines in the iron ore price, can be opportunities.
The low-cost producers are best placed to continue to grow and take market share in a lower price environment at the expense of higher-cost producers, particularly low-grade, high-cost miners in China. While margins are unlikely to be as favourable in future, they should still be attractive for the low-cost miners with several hundred million tonnes of high-cost Chinese iron ore still to be pushed off the cost curve. BHP Billiton and Rio Tinto remain Best Ideas and are both well placed to continue to extract cost savings through labour efficiencies and pressuring contractors and suppliers. By reducing capital expenditure, the major miners in particular have strengthened their hand and shareholders should be the beneficiaries.
