The steel supply chain will respond, partially or fully mitigating the impact of insufficient hot metal supply on finished steel markets. This Insight presents our expectations for the Chinese steel market balance over the winter “heating season”. We examine three scenarios and present a new base case which is consistent with CRU’s revised higher steel price forecasts which we are releasing to Market Outlook subscribers.
Chinese market to tighten further
Capacity closures in the Chinese steel sector over the last two years have fundamentally changed the structure of the industry. This winter will likely see the market tighten further as cuts to iron and steel production are mandated in order to try and manage air pollution in major population centres over the winter “heating season”.
The primary targets of production cuts are sinter and ironmaking facilities in Hebei, Henan, Shanxi, Shandong and Tianjin regions which together account for around half of all Chinese iron and steel output. These face having to make production cuts of 50% during the heating season starting around now and ending mid or late March 2018.
Instructions to reduce output are, or will be, issued to individual steel producers. The precise means by which this must be achieved is dependent on the individual company or steelworks, and may include an instruction to close specific facilities (sinter plants or blast furnaces), and/or reduce output at others which continue to operate, depending on the specific configuration of assets. The overall 50% target has been made clear and some enforcement of this through the winter is certain. As we write, some facilities have been ordered to close while others are still awaiting instructions though these could follow soon.
Any margin and price response to production cuts will be highly sensitive to changes in the market balance as, given recent structural supply reform, the industry lies at the boundary of cost-driven and allocation-based pricing. This means that a small change in market balance could provoke a large margin response and prices will be more volatile and no longer move with capacity utilisation.
In order to deal with such levels of uncertainty, we have developed three scenarios which describe possible outcomes over the next 6-9 months in terms of the extent of production cuts, and their impact on the domestic supply/demand balance, steel margins, input costs and therefore steel prices.
These scenarios are:
- Low impact – limited disruption to supply and the supply chain can make up for lost hot metal production elsewhere. More limited impact on price and margins;
- Base case – Our volume, margin and price forecasts in Market Outlooks fall under this case;
- High impact – maximum production cuts and no mitigating action results in very substantial price/margin response and consequential shifts in trade patterns.
These scenarios are distinguished by differing assumptions on the following:
- The extent of actual cuts in hot metal production during the specified timeframe of the heating season;
- The extent to which scrap supply can increase to meet increasing consumption from higher scrap rates and/or higher EAF production to compensate for lack of hot metal supply in primary steelmaking (BOF and EAF);
- The extent semi-finished and finished steel stock draw-down can compensate for lack of production of crude steel and rolled products respectively;
- The extent steel demand is diminished during the heating season, for instance by curtailment of construction activity.
These assumptions are summarised in the table below:
Assumptions common to all scenarios are:
Production cuts, even if partial, begin to be implemented from the declared start dates;
The maximum blast furnace utilisation in areas not required to make cuts is 95%;
The impact of cuts persists beyond the end of the heating season. This is discussed in more detail below.
There is a gross reduction in hot metal production from the above regions over the heating season of 66 Mt. This is then offset by an increase in production elsewhere of 25 Mt. This number is no greater than this as there are limits to the output gap blast furnaces in unaffected regions can make up for, and we assume 95% to be the limit of nominal capacity utilisation in blast furnaces here. Overall, the result is a net reduction in Chinese hot metal production of 41 Mt over the heating season. This is shown in the chart 1 below.
Lack of hot metal implies a reduction in crude steel production of 45 Mt, but this is offset by increased scrap consumption of 6 Mt and a drawdown in semi-finished steel stocks of 7 Mt, resulting in a net reduction in crude steel supply of 32 Mt. This is shown in the chart 2 below.
Charge more scrap?
Lost crude steel production volumes can be offset to some extent by additional consumption of scrap. Current scrap rates in BOF steelmaking in China are around 115kg/tls and 850kg/tls in EAF production. In theory these could rise to 200kg/tls and 1,080kg/tls respectively (or more), giving a theoretical boost to crude steel production which could more than offset the impact of any reduction in hot metal supply on crude steel production.
So the limit on scrap use is not a technical one and neither is it lack of EAF capacity. There is spare EAF capacity that could be utilized, while EAFs are not the subject of winter heating season cuts per se (although may be required to shut down at times of heavy air pollution). Rather, it is the availability of scrap which we believe will limit such a pickup in scrap consumption.
Our view is that the domestic scrap supply chain, in this timescale, is not able to respond to the necessary extent. Demands on obsolete scrap have already been high this year as operating mills have seen increasing scrap consumption as a route to boost productivity. It seems unlikely the supply chain can respond to deliver a boost of even greater magnitude.
The supply chain is largely deficient in low-cost, easy to collect scrap. However, China is expected to reduce its exports of scrap over winter in order to divert more supply to the domestic market, so some additional supply can be created. Overall, however, we limit the increase in scrap use to an additional 1 Mt/m over the heating season in the base case.
There are no reliable data for semis stocks in China, though we estimate these could amount to around 2 weeks of production or 30-35 Mt currently, lower than a more normal 3 weeks. Thus far we have seen little evidence of large scale semis stock accumulation in advance of the heating season. In the base case we estimate this is drawn down by around 7 Mt over the heating season, to a level of around 1.5 weeks of production which we consider to be the lowest operationally viable level.
The impact of crude steel shortage on hot-rolled finished steel production, and subsequent mitigating factors are shown in the chart 3 below:
Despite the assumption of semis stock drawdown, the base case still implies that a lack of semis availability will limit hot-rolled finished products production. Drawdown of finished steel stocks at mills and distributors may help mitigate the impact on market supply, and we assume a stock draw of 15 Mt over the heating season, which is equivalent to a fall to around 1 week’s production. More is not assumed given that stocks are already relatively low at present in the absence of any evidence of concerted stock building in this part of the supply chain in advance of winter production cuts.
Considering the above, our base case forecast is that hot-rolled product supply is reduced by 14 Mt over the heating season. However, we would expect the net impact on the supply/demand balance would be less than this by the amount of demand destruction resulting primarily from reduced construction activity over the winter period.
Construction works generates air pollution (for the most part dust), in particular land clearance and ground works, but also including operation of diesel equipment, demolition, transport of materials/waste to/from site and other activities. For this reason, the sector is also a target of emission controls over the winter period. Accounting for 50% of total Chinese steel demand, we have assumed a 6% reduction in output and therefore a 3% reduction in total steel consumption, which equates to 12 Mt over the period.
Therefore, the total market balance tightens by 1-2 Mt over the period. This may not appear to be material, but the impact on margin and prices is. This is because all parts of the supply chain are being stretched in order to barely meet market demand. This is explained fully in the later section on implications for margins and price.
Low impact case
The primary feature of this scenario is that actual cuts in output over the winter period in the impacted regions are some way less than the slated 50%. In this case, we have assumed cuts are half of those slated i.e. 25%, which equates to around 33 Mt.
This is then largely but not completely compensated for by an increase in hot metal output elsewhere, leaving a shortfall of 9 Mt. However, this can be made up for by a combination of increasing scrap consumption, drawing down semi-finished or finished steel stocks such that hot-rolled finished steel supply remains able to meet demand. In this scenario, demand may also fall, and if so, supply would adjust accordingly. The upshot remains no material impact on the supply/demand balance.
While this outcome is less probable than our base case, it is not substantially so. It is conceivable that weather conditions are such that only partial shutdowns or cuts are required, at least in some regions.
High impact case
The primary feature of this scenario is that actual cuts in output over the winter period are strictly 50% across the board, and there is no capability elsewhere in the supply chain to compensate for lost hot metal output which amounts to 75 Mt in impacted areas. With blast furnaces elsewhere maxed out, a net loss of 49 Mt is recorded. This then translates directly into 54 Mt of lost crude steel production and 50 Mt of lost hot-rolled finished steel production.
However, consistent with strict enforcement of environmental policy in iron/steelmaking and elsewhere upstream, construction demand for steel is reduced by 6% or 24 Mt, leaving a net deficit of 26 Mt over the heating season, or 52 Mt on an annual basis.
Tightness to linger after winter
Once production restrictions are lifted, it will not be possible to immediately restore hot metal output to former levels. Blast furnaces that have been idled will need to be restarted, but in the first place, idling a blast furnace is highly complex and risks of damage to refractories (e.g. cracking) on the inside of the furnace. This will then require repair, which, if not identified on idling will delay restarts. Then, the restart process itself is highly technical and may require support from experts (e.g. equipment manufacturers). There is a risk of furnace damage if not carried out correctly. Finally, after a restart, it will take at least two weeks (and as much as four) to get ‘useable iron’ at nominal capacity.
At the same time, many of the blast furnaces which have been producing at high operating rates over the winter months will require maintenance, and as a consequence will need to be brought offline. Generally furnaces will have a 4-10 day maintenance period annually – it takes time as furnaces need to be cooled. If operations have been extended beyond this period, there is a high risk of damage, resulting in reduced capacity.
Therefore we foresee a ramp up period of 1-2 months after the official end of the heating season, where production is still limited for technical reasons. In addition, stocks of semi-finished and finished steel will likely have been run down to very low levels by the end of March, and so there will be additional restocking demand. Market tightness will therefore likely linger in this period, and more so and potentially for longer in the high impact scenario.
Margin and price impact
As previously presented, Chinese steelmaking capacity has been cut as part of a structural supply reform program. This has meant that any further cuts to effective capacity, such as over the winter heating season, will likely shift pricing power into the hands of sellers as pricing moves from a cost to allocation basis.
Base case and low impact scenario margins set to rise
Our base case forecast is that a small market deficit emerges over the coming winter months. In volume terms, this does not appear to be material, but a crucial point is that it has been achieved by stretching the rest of the supply chain, namely:
- Increasing blast furnace capacity utilization rates in the rest of China to their limit (95%), while those in impacted areas are effectively limited to 100% of what they are allowed to produce;
- Increasing scrap use in steelmaking, thereby demanding more obsolete scrap from domestic sources, and simultaneously reducing available scrap for export;
- Drawing down semi-finished steel and finished steel stocks, and from levels not especially high currently;
- Assuming demand will be reduced, almost to by the extent of reductions in supply.
Therefore, margins will be stronger, likely substantially so, even though there is no material physical shortage arising as such. As a consequence, more production will likely be diverted to the domestic market where margins will be strong, and so steel export volumes will be reduced. We would still expect China to be a net exporter in this instance, but less so than is currently the case, and the price of those exports will be higher.
In the low impact scenario, no market deficit arises at all, yet the supply chain is still placed under some stress for the reasons cited above, though to a lesser extent. Therefore this scenario still implies stronger margins than would be the case without winter production cuts, and somewhat less pressure on export volumes with some uplift to export prices.
High impact case could see margins and prices spike
In the high impact case, a 26 Mt (c.52 Mt annualized) net deficit arises which is substantial in volume terms. This compares with Chinese net export volumes of around the same magnitude. This is a substantial market shortage and implies a surge in margins and domestic steel prices. This would then heavily disincentivize exports and, given extent of margins/prices in the domestic market, incentivize imports. This has the potential to turn China to a net importer in aggregate, at least for a period of time
- Global implications
The implications of all the above scenarios for market elsewhere are:
- Chinese net export volumes will be lower;
- Exports will be priced higher;
- Therefore market prices elsewhere will be higher due to less volume and price competition, and as capacity utilization rises;
- Steelmaking raw materials prices will change:
- Iron ore and coking coal prices will be lower as demand falls;
- Scrap will be priced higher as in more demand;
- Lump premiums will be higher than would have been expected. We have demonstrated in past analysis that the lump premium is linked to variable conversion costs of sintering and that, if the price of lump rises, it becomes more advantageous to make sinter and vice versa. However, the recent directive to cut sinter output has reduced mills’ flexibility to make a choice between lump and sinter. Orders have been given to some plants to fit roofs over stock piles or fit scrubbers to stacks to reduce emissions. With the supply of sinter constrained, iron makers have been desperate to source an alternative burden, to ensure continued steelmaking, and lump prices have shot up.
The upshot of the above is that margins for steelmakers elsewhere will rise. Meanwhile, the ability for EAF producers elsewhere to make up for lost Chinese production volume may become limited, especially in the high impact case, by ongoing issues with graphite electrode supply. CRU has produced a bespoke study on this issue, and more details are available here.
In addition, we will provide further Special Feature analysis of the wider implications of China’s winter heating season to Market Outlook subscribers in due course, and an update to our price forecasts in the second week in November, and on an ongoing monthly basis through the heating season.
We expect 25-50% cuts in hot metal production during the Chinese winter heating season – a seasonal supply shock which is overlaid on an already structurally tighter market given cuts to steelmaking capacity over the last two years. Though other parts of the supply chain can respond, crude and finished steel availability will diminish and the domestic supply/demand balance will tighten. Margins will rise, and to a greater extent than anticipated falls in input costs. Therefore steel will be priced higher relative to costs in the domestic market, meaning net exports will be diminished and the price of those exports will rise.
On 30th June 2020 a team of CRU Analysts discussed the outlook for iron ore, thermal coal and manganese in South Africa, in the context of evolving lockdown regulations....