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What China's crackdown on iron ore could mean for North American investors

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At the beginning of May, China made good on its plans to crack down on the iron ore industry. Rumors of the crackdown had been in circulation for months beforehand. The Chinese government's primary concerns centered upon steel mills flouting overcapacity and pollution policies. Finally, in late February iron ore prices fell drastically after one stock sale in particular.

Chinese steel mills had fallen into a more dangerous financing pattern, which led to the current crisis. They would use the only collateral they had—iron ore—to attain financing from other companies which could get bank loans. These companies could get the bank loans at standard rates and then loan to steel mills and higher rates; beggars, after all, can't be choosers.

This cycle is the primary reason for increases in Chinese iron ore exports despite existing surpluses and an economic downturn. The ultimate fear of the Chinese government, and anyone who thinks it through, hopefully, is that should steel mills default, unscrupulous lenders could simply dump huge amounts of iron ore onto the market. In fear of this major drop in prices and resulting crash, the government acted.

As a result of these issues, the China Banking Regulatory Commission (CBRC) instructed banks to increase control over iron ore import letters of credit, investigate all such deals closely, and submit detailed reports as of April 30, 2014; this caused iron ore futures in China to fall 5 percent. This follows the tightening of property credit sectors in the Chinese economy which had already made it difficult for steel mill owners to pursue traditional sources of financing.

Despite these imminent changes, China continued to both produce and import iron ore leading up to the crackdown. For example, plants in the Hebei province which had been targeted for shut down based on their propensity for pollution, were demolished—but the only plants that were destroyed were already shut down based on the owners' insurmountable debts. Meanwhile, new plant construction was underway elsewhere in the area.

Almost immediately after the CBRC issued its mandate to Chinese banks on April 18, there was a 5% drop in iron futures on the Dalian Commodity Exchange. As of May 2, spot iron ore prices were about $108.50 per ton, down from $109.55 per ton on April 28. Also as of May 2 Morgan Stanley reported that seaborne iron ore supply—of which China consumes about two-thirds, worldwide—will exceed demand by around 79 million tons in 2014 and 158 tons in 2015. In fact, some estimate that there are approximately 110 million tons of iron ore sitting in Chinese ports, only 40% of which is collateral used in financing. Nevertheless, the major global iron ore producers including BHP Billiton, Rio Tinto, and Vale, have all increased production this year.

By the end of May 2014 iron ore prices fell lower than they had in nearly two years, to $91.33 per ton. In early June, the Bank of China, one of the country's largest, instituted monthly quotas in its Shandong branches to limit the number of letters of credit issued for imports of iron ore. The central office of the bank also told local branches to refuse letters of credit for importers who had not secured buyers for iron ore imports. This measure was designed to reduce stockpiling.

In early June sources told journalists for Steel First that the steep drop in iron ore prices was driven by the Chinese crackdown, not the rest of the issues facing the market. Prices have recovered somewhat but they remain less than $100 per ton.

This drop in prices, however, should not be a true surprise for those watching the market in this area. While this particular cause may come as a shock, the price of iron ore has been forecast to fall between 2014 and 2015 for some time now. This is because experts believed that many major mining projects would go online during these years and there would be a glut of iron ore on the market. Additionally. Just as the Chinese crackdown got underway, India ended its ban of iron ore mining. While Indian mining is now capped at 20 million tons per year—not a large amount—this is adding to the overall surplus on the market.

By mid-June iron ore prices dropped to $89 per ton, a two-year low. Towards the beginning of July prices recovered somewhat and rose to $96.5 a ton. The outlook for iron ore is still bearish, however. Chinese steel mills are now understandably reticent to act aggressively. Iron ore inventories of Chinese ports remain as high as they have ever been; as of the beginning of July 113.7 million tons sat idle there. Many Chinese steel producers have at least a month of inventory on hand, and are stepping away from the market. In short, although China is by far the world's largest iron ore consumer, in order to restore balance to its economy, it will need to shift from importing to consuming what it has—as major iron ore producers continue to increase production hoping to gain even more market shares.

When the iron ore market suffers, the biggest producers don't go out of business; they can maintain profitability through high volume even when prices are low, and when smaller companies go out of business they actually gain market shares, so they might as well be aggressive even when the market is bad. But for smaller iron ore producers, the outlook isn't so rosy.

And even when the bigger producers stay profitable, they don't necessarily meet shareholder goals. Experts speculate that if iron ore prices hover around $90 per ton, even the biggest boys like Rio Tinto and BHP won't be able to buy back shares from their shareholders. This could signal trouble for North American iron ore investors.

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