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.
Watch: How China’s reforms impact its steel making industry.
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.
We see 80% utilisation and a durable net profit margin for steel mills of approximately 3-4% on average over the course of the cycle as an equilibrium that supports financial sustainability for steel producers without putting undue pressure on the competitiveness of trade-exposed downstream steel end-users.
We consider this shift to have profound implication for steel making raw materials. It is our experience that steel mill procurement managers behave differently under zero, low and high margin conditions. When margins are low or non-existent, productivity incentives are also low. This encourages the use of lower grade raw materials as a cost containment measure. That compresses the premiums paid for higher grade met coal and iron ore and trims the discounts faced by lower quality products. In the reverse situation - i.e. margins are high and productivity incentives are amplified - the mills’ procurement teams change tack, seeking out the highest quality raw materials to serve the productivity imperative, while lessening their interest in lower quality products accordingly.
This has been the key driver behind the increase in the premiums paid for higher grade met coal and iron ore since late 2016 - and the rising discounts applied for lower grade materials over the same time period.
Over the Chinese winter, we observed that the “2+26” environment restriction plan in Northern China sent short-term steel margins to new highs. This incentivised mills outside the restricted area to run close to full capacity. As a result, during this period we observed record spreads between the 62% Fe fines index and lower quality (including the 58% Fe fines index, and branded ores with lower specifications than this index) iron ore fines; as well as an elevated differential between premium low-volatility coking coal (PLV index) and mid-volatility coal (PMV index) and weaker coking coals. Lump and pellet premia in iron ore also appeared to have been strong, although volatile, with the former hitting a record in the September quarter of 2017. While some of the more extreme spreads evident over this period have since receded, that is an entirely reasonable development, and consistent with our medium-term thesis.
Bigger, coastal, greener: China’s steel future brought forward
We believe that China will continue to pursue its supply-side reforms, but the strategic focus is expected to shift away from capacity removal towards industry optimisation and upgrading. That is our interpretation of the various pronouncements made at the most recent Party Congress and through other official platforms. We have observed that steel mills across the nation have been actively upgrading their production facilities – with bigger and more efficient blast furnaces and cokeries designed to produce high quality steel products.
At the same time, China’s increasing focus on environmental protection and ‘ecological civilisation’ have prompted the steel industry to simultaneously pursue greener capacity that can meet increasingly strict emission standards.4 In particular, far more stringent Sulfur Oxide (SOx) and Nitrogen Oxide (NOx) standards have been introduced. Each of these observed trends will support the demand for high quality seaborne raw materials going forward. That, in turn, is expected to support the maintenance of quality differentials closer to those of 2017 than to those of the previous low margins, prior to the environmental restrictions.
Our view that China’s steel mill fleet would trend in a 'bigger, coastal, greener' direction over the course of the next decade has been consistent. However, China’s bold implementation of its supply side reform policies have brought this expected future state forward to the present.
Given that this surprise is mostly about timing, this disruptive development has been incorporated relatively easily into our strategic thinking. That strategic framing of the likely future needs of our major customer in turn feeds into thoughtful decisions on how we look at developments of our mines.
BHP’s efforts to increase the transparency of the markets for steel making raw materials, most notably through the move to indexation, continue to prove their worth.
The advanced information that is available to both producers and consumers under the indexation model of today provides a fair and transparent marketplace where scientific value-in-use principles can be applied, and changing attitudes observed in real time. It is important to remember that without BHP’s pioneering efforts to drive this transparency through price reporting agencies, there may be no differentials to observe; and no subsequent debate as to their durability.
The science of value in use
Our portfolio includes a stable of long life, expandable, low cost Premium Low Volatile (PLV) coking coal assets. PLV coals produce high strength metallurgical coke (measured on a “coke strength after reaction” index) enabling high blast furnace productivity with lower external energy requirements. This fulfils the needs of advanced, large scale blast furnaces. Low sulfur content is a further advantage under heightened SOx controls. Around three-fifths of our metallurgical coal production is linked to the PLV index.
We also offer a suite of high quality fines and lump iron ores, providing customers with a choice to meet their specific needs in an ever-changing environment. In addition to Fe content, the value-in-use of a particular iron ore offering is also related to the presence of silica, alumina and phosphorous (collectively “gangue”), as well as minor impurity elements that impact steel making costs and steel quality5. We recognise that different mills have different sensitivities to these impurities depending on their unique factors such as equipment size and constraints, end product quality and impact of any local ore supply.
Differential customer requirements are value opportunities for our Marketing business, where we assess value-in-use scientifically to place our products where they will be appreciated the most.
BHP’s ores are also among the lowest in terms of sulfur, and other minor trace elements such as vanadium, zinc and arsenic, which allows steel mills to reduce environmental emissions while improving steel making costs and steel quality. In particular, Newman Blended Lump - the highest Fe, low gangue lump from Australia – enables higher hot metal production and lower energy requirements in the blast furnace. The direct charge into the blast furnace also avoids costs and emissions associated with sintering and pelletising processes. Sintering is a highly air polluting activity that is subject to periodic bans in the major metropolitan areas of Northern China. Lump ores contributed around 24 per cent of our production in FY2017.
Building on more than half a century of prior iron making experience, BHP also continues to support cutting-edge research in iron and steel making at universities and institutions both in Australia and overseas. Through these initiatives, we endeavour to work with our customers to minimise the environmental impacts of their production while helping them to achieve both cost and production efficiency from their furnaces.
1 One of the curiosities of the recent protectionist measures announced by the US is that the global steel industry is enjoying very favourable conditions. Traditionally, protectionist pressures rise when industries are under stress. On this occasion, the cycle trough was some time ago, but the tariffs are only being instituted now, with the industry on an upswing.
2 The “electric arc furnace” and the “basic oxygen furnace” are the two major steel making technologies globally. The share of EAF globally is around one quarter, with BOF at three-quarters. In China, BOF dominates at 90%, with the remaining tenth split between IF and EAF – until the IF were closed abruptly.
3 Supply disruptions in the seaborne trade also contributed to the lift in prices.
4 The greenest move of all, of course, would be the application of Carbon Capture Use and Storage (CCUS) technology across the sector. For more on this possibility, including BHP’s partnership with Peking University on CCUS in the Chinese steel industry, go to our blog.
5 These include vanadium, copper, arsenic, chromium, lead, zinc, sulfur, cadmium, mercury, fluorine and chlorine.