$name

We estimate about two-thirds of the lift in Chinese steel making utilisation rates and margins since the introduction of supply side reform will be sustained in the long run. Competitive suppliers of high quality steel making raw materials will likely benefit the most from this change. 

The supply side reform of China’s steel industry has been one of the biggest stories in commodity markets over the last two years. Prior to China’s reform, steel mills at home and abroad had been struggling with severe over-capacity and persistent financial difficulties. Post the reform, industry wide profitability has improved materially.¹

How did we get here? First of all, in late 2015 President Xi announced the supply side reform. The steel element of this plan is to remove 150 Mtpa of capacity by 2020. After initially focussing on the less-disruptive removal of idle electric arc furnace (EAF) and obsolete basic oxygen furnace (BOF) capacity², the authorities shocked the industry with their second move: removing around 120Mtpa of induction furnace (IF) capacity essentially ‘overnight’ in late 2016. That drastically tightened the steel market balance at a time when end-use demand sectors were performing well.

The result was that steel industry utilisation rates spiked by around 15 percentage points from the cycle trough, from below 70% to around 85%. Steel making margins jumped sharply along with utilisation rates, despite a sharp lift in met coal prices that was due in part to the coal supply side reform policies that were being pursued in concert.³

These developments have raised an obvious question: how much of the observed improvement in upstream and downstream market conditions can be sustained in the medium to long run?

You already have our basic answer – we estimate about two thirds of the utilisation spike will be sustained, implying a long run utilisation rate in the vicinity of 80%. That is in line with the target presented in China’s Steel Industry Upgrade Plan (2016-2020). That outcome would be consistent with healthy industry profitability and sustained free cash flow generation. That will help steel mills strengthen their balance sheets, which had weakened significantly in the lead-up to the policy intervention. Achieving financial sustainability is one of the ultimate objectives of the reform, with a liability-to-asset ratio of 60% the specific industry wide target.