There seems to be a colossal iron ore arbitrage going on in China.
According to a Reuters report a few days ago, and then another yesterday from ANZ’s head of commodity research, Mark Pervan, there are currently 80 bulk ships waiting off China to unload iron ore. That’s 10 per cent of the global Capesize vessel fleet.
A huge spike in demand for iron ore from China has, in turn, pushed the Baltic Dry bulk shipping rates index up 200 per cent since early April. The Baltic Dry index is a composite of four indices, of which the Capesize index has seen the biggest rise – up 315 per cent.
This in the midst of a global recession. The iron ore shipments are simply not supported by any underlying increase in demand for steel. Steel production in China was relatively strong in May – an annual rate of 544 million tonnes, compared to 500 million in 2008 – but steel inventories are also rising rapidly. Exports are still falling, albeit at a slower rate, and underlying steel demand is weak.
In fact the iron ore unloaded in China this year is being stockpiled, mostly at or near the ports. Those facilities are now full.
The demand for iron ore has been driven by traders playing the arbitrage between the low iron ore spot price at present and the expected long term contract prices – that China has not yet signed off on, but is moving towards.
The spot price for iron ore fines has fallen 60 per cent from its 2008 peak. Japanese and Korean steel mills have agreed to a 33 per cent cut in the contract price for the next financial year; the Chinese are holding out, complaining about the BHP/Rio joint venture plan (as are the Japanese, Korean and European steel mills).
The trade looks like a sure thing, especially with the Chinese government throwing its weight around. However, a couple of days ago the Steel Business Briefing reported rumours that China would accept 33 per cent as well, but that would produce a decent, quick return on investment.
However, in the process of playing this arbitrage, the traders have created a massive supply overhang. Mark Pervan says they have simply misread the market, and that steel demand will be unable to absorb the iron ore stockpiles.
While the stockpile overhang clears, the shipping rates are likely to crash again. Those who have been seeing the rally in the Baltic Dry index as a leading “green shoot” are likely to be disappointed – indeed the index has fallen 15 per cent in the past four days.
Morgan Stanley’s Asia chairman, Stephen Roach, has just put out a note entitled Asian Relapse, in which he suggests that China is vulnerable to relapse in 2009 as the government stimulus fades and is not replaced by a US-led snapback in external demand.
The iron ore arbitrageurs may have made the coming relapse a little more severe.
