Mon, August 14, 2017 11:06 am

An Excerpt From Our DTC Flash©: The Week Ahead

So what is behind the run up in coking coal prices? Our feeling is all of the factors above definitely have a role in it but are not the driving force. According to Bloomberg, Chinese domestic Hot Rolled Sheet spot prices hit a four year high this week driven by expectations that China will support stimulus efforts through the end of the year to ensure a smooth change of party leadership (something we posited in our August monthly update) and, ironically, widely reported efforts by the Chinese government to rein in excess steel capacity. Other steel inputs are on a tear too. Metal Bulletin has reported CFR Qingdao Iron Ore prices have soared too, up nearly 44% in less than two months.

Several market experts have cited high steel prices being behind the rise in iron ore and coking coal prices. However, as we just noted, a large part of the reason for the increase in steel prices is expectations that excess steel capacity will be reined in. Our take here, therefore, is that there is quite a bit of speculation in coking coal and iron ore coming out of China driven by higher steel prices, ignoring the disconnect that those higher steel prices are due to less production. Less production should hurt input prices, not push them higher. China’s influential China and Steel Association (CISA) seems to agree with us, this week calling steel price behavior “speculative” and not “driven by market demand or reduced market supply.”

While there are clearly some short-term supply issues in the coking coal market as we’ve outlined above, commodities prices in China appear to have surged after higher steel prices and wider margins at steel producers were seen which ostensibly would naturally lead to more steel production and therefore more demand for inputs like iron ore and coking coal. However, such a thesis ignores the reality that part of the surge in steel prices appears to be attempts to reduce steel capacity and supply as evidenced by output restrictions in steel-heavy provinces like Hebei this year, not solely by an increased demand for steel. Steel producers in 28 cities have been ordered to severely curtail output this winter in order to improve air quality, coincidentally, as a nod to our theory that mainline industry output is being maintained through leadership changes this fall, right after a change in party leadership is complete.

According to local media, last week Hebei Province, for example, was ordered to cut output in half from November through February. To put that in perspective, according to the Hebei Metallurgical Industry Association and local media reports, the province produced roughly 23% of Chinese steel in 2016. Using 2016 production levels from worldsteel that equates to 92.5 mm MT of steel. Halving production for four months from November through February, therefore, would be just over 11.5 mm MT of steel output, nearly the annual output of Canada or nearly 15% of the annual output of the United States in 2016. While we do not believe actual steel production will fall by levels quite that large across China, there are still clearly very strong policy-related risks that seem to be ignored by the recent spike in coking coal prices. We remain gravely concerned that such a spike in coking coal prices is a bubble that will burst as soon as regime change is complete in China.