China Steel - Overproduction and Lower Prices to Persist

China’s steel industry output continues to rise notwithstanding slowing economic growth, falling prices for steel, and poor profitability at the steel mills. Fitch Ratings believes this paradox can be explained first by the larger steel mills’ priority of maintaining economies of scale and market share; and, second, by smaller steel mills taking advantage of the recent fall in raw material prices to ramp up production.

Fitch believes that the prices of steel and related raw materials - including iron ore and coking coal - are unlikely to rebound in the short term, but rather are looking for new equilibriums that take into account the increasing supply of raw materials and demand growth for steel which is likely to be slower. Price weakness should continue during H212 and through to end-Q113, due to weak seasonal demand typically associated with the winter period.

Industry rationalization is necessary for a sustained improvement in profitability, but Fitch does not expect this in the short term. The financial resources of the large steel mills are stretched as a result of prior consolidation activity and weak profitability since 2008. Some consolidation has taken place among some of the larger steel mills, but this has been confined largely to activity within the same province - given the important role that each steel mill plays within its own local economy.

Chinese crude steel production reached a record 61.693 million metric tonnes (mt) in July 2012, 2.5% higher than the previous month and 4% higher than in July 2011, according to data released by China’s National Bureau of Statistics. Moreover, the average daily steel output during the first 10 days of August totalled 1.97 million mt, up from 1.95 million mt during the last 10 days of July, according to data from the China Iron and Steel Association (CISA).

At the same time as output is rising, China’s steel mills are facing falling steel prices, weak profitability, and soft demand for certain products such as steel plates. Chinese domestic hot-rolled coil prices fell to CNY3,511/mt in August, their lowest level in 33 months. Downward pricing pressure on steel is being driven by the country’s slower industrial production growth of under 10% since April this year, compared with 13.9% in 2011. Demand from China’s shipbuilding, machinery and heavy equipment sectors is especially weak - resulting in negative production growth for steel plates so far in 2012. Total profit in the steel sector fell by 68.1% in H112 from a more robust H111, according to the National Development and Reform Commission.

The decline in steel prices is in turn depressing the prices of iron ore. Iron ore with a 62% iron content has now fallen below USD100 for the first time since 2009 - and is down by 28% so far in 2012. Fitch believes that this lower cost factor is encouraging some of China’s smaller steel mills - with a production capacity of less than 2 million mtpa - to boost production. However, this is exacerbating the oversupply situation in the context of weak demand.