2020 PREVIEW: Profitability to continue driving feedstock procurement strategies of Chinese steel mills

Despite environmental issues being on the agenda, including the announced switch from the basic oxygen furnace (BOF)- to electric arc furnace (EAF)-based steelmaking process, profitability has been and will likely remain the key driver for Chinese steelmakers when it comes to choosing steelmaking raw materials, Fastmarkets analysts forecast.

This has been evident in the decoupling of 62% Fe and 65% Fe iron ore prices in recent years, as well as in China’s growing interest in imported iron metallics and semi-finished steel through 2019.

By late 2019, combined monthly imports of iron metallics and semi-finished steel into China reached the highest level in a decade. In November, the total volume was just under 1 million tonnes. This included 203,709 tonnes of merchant pig iron (MPI), 155,764 tonnes of hot-briquetted iron (HBI) and 617,209 tonnes of semi-finished steel, including slab, billet and bloom. That said, the volumes – relatively significant for international markets of merchant metallics and semis – are still tiny compared with China’s iron and steel production volumes.

Total imports were the highest since July 2009; and there are other similarities between 2019 and 2009. Price spreads for semi-finished steel over iron ore have dropped significantly year on year in 2019, making semi-finished steel an attractive option for some Chinese producers. The same situation has been observed in the iron metallics market, as the chart below illustrates.

There were similar trends in both 2009 and 2015. In 2015, however, domestic demand for steel products plummeted in China, pushing steelmakers to export semi-finished steel, despite the 25% export tax at the time. To get around the duty, Chinese exports of billet were misclassified as a type of alloy steel bar in 2015, enabling traders to avoid paying export duties and even qualify for rebates from sales taxes available for higher value finished products. Finished steel producers were not in a position to benefit from lower spreads by importing semis. They themselves contributed to the narrowing of those spreads by exporting billet.

In 2019, much like a decade ago, price attractiveness of semis, as well as of merchant iron metallics, versus iron ore appears to have been driving the increasing appetite for imports. This implies that China’s appetite for imported semi-finished steel may be a temporary phenomenon and is likely to cool down as price competitiveness versus iron ore fades. We do not believe environmental pressures will trump the economics despite the initial theories of some market participants.

The so called “winter cuts” – when the Chinese government imposes production cuts to improve air quality in northern China from October to March – would appear to have little impact on imports or even production. Capacity utilization rate surveys reveal few reductions at this time of year.

According to Steelhome data, China’s average blast furnace utilization rate averaged 86% in October-December, which is similar to readings since the beginning of 2017. Although rates did come down from over-90% levels recorded earlier in 2019, they remain elevated. What takes place during periods when the winter caps are imposed is not a total output shrinkage, but rather a shift in production to mills in other regions. The overall impact on total Chinese iron and steel production is therefore limited.

Why has China been boosting imports of iron metallics and semi-finished steel?
While metallics and semis imports surged, ferrous scrap imports collapsed last year. In the first 11 months of 2019, China imported only 183,042 tonnes of ferrous scrap, compared with 1.34 million tonnes in the corresponding period of 2018, representing an 86% year-on-year decline. In part, the pick-up in iron metallics imports was to replace scrap imports, but we believe the trend is mostly related to the price competitiveness of metallics and semis versus both seaborne iron ore and Chinese domestic heavy steel scrap.

By the end of the year, the market consensus also shifted toward price attractiveness as the main reason for China’s buying interest in importing iron metallics and semi-finished steel.

Expensive scrap challenges BOF-to-EAF shift
Although scrap-based steelmaking is being viewed as environmentally-friendly, there are limitations and challenges to it. Firstly, profitability. On a global scale, an average BOF mill had crude steel production costs exceeding those at an average EAF mill in the fourth quarter of 2018 for the first time that decade. The gap widened into 2019, according to our Steel Cost Service, given rising iron ore prices, but a shift toward EAF-based steelmaking might not make sense from the cost point of view if raw materials prices change course.

Chinese BOF-route (integrated) steelmakers are very sensitive to profits in our opinion. This view is evidenced by these steelmakers navigating between lower- and higher-Fe-content iron ores, depending on their order books and margins, despite environment-related restrictions. Scrap prices, which were substantially higher in China than elsewhere in recent years, dropped below hot metal costs only after iron ore prices jumped above $100 in May. Other challenges to the BOF-to-EAF switch include the build-up of residuals in scrap over time that make it less desirable for certain applications, as well as the fact that many BOFs in China are fairly new. This makes justifying investment into new EAFs more difficult.

Operating margins define iron ore procurement strategies
Chinese steelmaking margins were squeezed last year but recovered somewhat in the last quarter due to a slight rise in steel prices. As margins rallied so the premium for 65% Fe fines over 62% Fe fines increased. In general, iron ore prices were above our expectations for December, but we are still anticipating a downward price correction this year. A dramatic, by Chinese standards, reduction in industrial activity growth this year, contrary to the strengthening global trend, will negatively affect Chinese steel demand and supply – particularly pig iron production – which poses a downside risk to iron ore demand.

Although iron ore supply can be far more important than demand for price direction at this time of year, as we approach the anniversary of last year’s tragedy in Brazil, falling demand is likely to negatively affect prices.

Vale was forced to halt several mining operations after a tailings dam failure at its Córrego do Feijão mine in Brumadinho on January 25, 2019.

Chinese port stocks remain stubbornly high, at around 130 million tonnes, and high prices could continue to stimulate Chinese iron ore production, which rose strongly last year. Imports of iron ore into China also revived strongly from the second half of last year, which suggests that supply-side competition could intensify if demand fails to outperform.

What’s in store for metallurgical coal?
In the near team, and as we have observed over the past few years, Chinese demand for coking coal (and especially so demand for imported material) correlates with iron ore procurement strategies. Those, in turn, are a function of operating margins at steel mills, demand for finished steel products and capacity utilization rates at blast furnaces.

The share of coking coal imports increased with higher demand in China in 2019, as well as in 2017. The share dropped in 2018 when total demand was broadly flat year on year. These changes are related to iron ore buying approaches. Fluctuations in coking coal imports are more dramatic compared with iron ore, because China is less reliant on imported coal but also more reliant on Australia-specific supply, which can be heavily affected by the weather, typically the rains in the first quarter but to some extent the bush fires across New South Wales and Queensland over the fourth quarter 2019 and first quarter 2020. A drop in coal imports in 2018 was accompanied by elevated margins and higher usage of 65% Fe ores (as illustrated by a drawdown from Brazil-origin port stocks), and the opposite occurred in 2019.

Looking further ahead, availability of ferrous scrap in China is expected to increase. Should this put pressure on scrap prices (provided scrap collection follows suit) and make the secondary raw material more price-attractive compared with hot metal, this would be an additional incentive to increase scrap use at integrated mills and in turn reduce the demand for metallurgical coal. In the near term, the price outlook for comparatively low-priced seaborne metallurgical coal (under $150 per tonne cfr in December 2019 compared with a four-year average of around $180) is strengthened by the fact that mills are encouraged to use lower-grade iron ores, which require more fuel (coal) to remove impurities. Upside risks are also being provided by the tier 1 coal prices in China, which before tax remain at an elevated premium over $55 per tonne higher than seaborne coal. This contrasts with an average premium $30 per tonne lower.

This article has been written by our team of analysts at Fastmarkets, who are responsible for arguing our independent view on market developments and forecasting their future performance.