We remain in the wrong type of global economy for commodity markets, with emerging market demand weak, China adopting a less commodity-intensive growth path and global industrial production struggling for any growth. This comes after a period of high investment in supply capacity – the likes of which has never been seen. No wonder most commodity prices have been flirting with multi-year lows. However, in Macquarie Research’s opinion the dry bulk freight market is facing more amplified problems than most – particularly relating to the demand side of the equation.
The long-favoured explanation for the freight market’s demise is overbuilding of new vessels, which has left a substantial overhang of supply capacity in a notoriously inefficient market. However, just as capacity growth has been moderating, demand growth, which ran at around 6% CAGR in the decade to 2014, has collapsed. Macquarie’s expectations for iron ore and coal trade suggest that, structurally, the demand picture will not get better from here. Thus, although current freight rates are unsustainably low, there is not much to suggest things will turn around quickly.
With iron ore, metallurgical coal and thermal coal all effectively priced from a CFR China reference, the winners from low freight rates are bulk commodity producers, who receive a higher FOB price at the export port, all else being equal. In the CFR China, iron ore assessment freight is now just 6% of the price versus more than 35% in early-2008. Of course, all else is not equal, and this has not been enough to offset the headline fall in iron ore prices of the past few years. It does, however, illustrate that miners could be in even worse shape than they are currently.
One of the things that has often been taken for granted by freight-market participants is that trade volume growth, particularly after the exceptionally strong years of 2010 – 2014, would continue. But the China slowdown, the less commodity-intensive nature of world growth and a shift away from coal-fired power generation means that these expectations fell flat on their face in 2015. The research group’s expectations going forward are negative too.
Iron ore, thermal coal and metallurgical coal combined account for around 60% of world seaborne bulk trade. Macquarie estimates that these volumes fell 1% last year and the group expects them to continue to fall at a similar compound rate over the next five years. Structurally, there is no positive story from a seaborne demand angle. In iron ore and metallurgical coal, the research group sees global pig iron as having peaked due to no steel demand growth and an increase in scrap usage in China. In thermal coal, Macquarie thinks consumption has more or less peaked, while seaborne trade has been additionally cut substantially by Chinese protectionism and higher domestic supply in India.
The demand collapse is unfortunate because net fleet supply growth has fallen to the lowest level in over a decade. However these growth rates are still positive, the legacy of the overcontracting that continued to be seen after the global financial crisis and, most recently, in 2013. Given the three to four year cycle between contracting and actual delivery, the expectation is that net fleet growth will rise this year again. After 2016, the orderbook looks leaner and with new vessel contracting having fallen to its lowest level since 2001, supply growth should slow more significantly after that. Much will depend on how scrapping evolves. It was close to an all-time high in volume terms last year but is challenged by the fact that the current fleet is so young by shipping standards. A combination of freight rates and vessel age, rather than the scrap steel price, is ultimately what drives scrapping.
Of course, the iron ore market is of particular importance for freight. After continuous growth since 2001, global iron ore trade very much stalled in 2015. However, given the drop in global steel output, this is actually better than it might have been.
Total 2015 seaborne iron ore trade grew little more than 15 million t over 2014 volumes, which is a stark change from the more than 120 million t annual additions seen over 2013 and 2014. Perhaps the surprise has been the relative market efficiency over this transition, with supply exiting the market on a steady basis as prices moved lower.
With global steel production down 3% over 2015, and set to fall again this year, iron ore has had to react, and, from the start of 2015, production has trended back towards zero growth. However, even that exceeded pig iron production volumes at iron ore importers, which was in negative y/y territory all year. To balance the books, Chinese domestic ore production took the brunt of displacement.
With Chinese blastfurnace output down 2% y/y in 2015 and in Macquarie’s opinion set to decline further in the coming years, the research group now expects a slow but steady declining trend in import volumes through the end of the decade. This is reinforced by its view that Chinese domestic iron ore output will remain relatively resilient from here. On Macquarie’s modelling, China does not ever reach the 1 billion t mark that was long expected by major iron ore producers. Essentially, Chinese steel output stagnation flows straight through into iron ore trade stagnation.
This certainly does not mean the Chinese market is static in terms of supply origin – in fact, far from it. While Australia has grown total exports consistently, all of this growth has gone to China. In contrast, exports to Japan are trending lower. Brazilian material (dominated by Vale) has done the opposite – falling into China but rising into the traditional markets of Europe and Japan. While at a headline level, iron ore trade looks uninteresting, the sub-plots persist.
Key among the changes in Chinese imports has been the disappearance of supply from many smaller countries as prices have fallen. China’s imports from countries outside of Brazil, Australia, India and South Africa were just 54 million tpy in 2008 and 82 million tpy in 2009, but grew to 212 million tpy in 2013 amid rising prices. This process has reversed equally as fast, with 2015 seeing just 110 million tpy of this material. Many of these countries – Swaziland, Honduras, Mexico and the US for example – now ship no ore into the Chinese market. As a result, since 2013 the share of these suppliers in Chinese imports has fallen from 25% to 12%, while Australia has grown from 50% to 64%. This trend is set to continue with the arrival of the Roy Hill mine to the market, with first shipments due imminently but the real impact of the ramp up felt into 2Q16.
With the exception of Vale’s 90 million tpy S11D operation, which Macquarie have been ramping up from 2017, Roy Hill marks the last 25 million tpy plus ramp-up expected from the majors (who Macquarie classify as BHP Biliton, Rio Tinto, Vale, FMG, Anglo American and Roy Hill). Despite this, the group still expect to see growth from these companies of ~4% over 2016, assisted by strong performance at existing assets. While ones, such as Rio Tinto’s Hamersley, have been supported by greenfield ramp-ups, even the ‘declining’ Southern and Southeastern systems for Vale are up, helping the majors regain some market share.
The arrival of Roy Hill in turn raises the question of where this material will be placed. Given that the key backers of the project are Korean, Macquarie expects this to be the destination for much of this material. With Korea now an ex-growth market in terms of steel output, someone will have to make way. Presently, BHP and Rio are dominant in terms of supply into Korea and look most at risk of losing share to Roy Hill. Depending on how the marketing arms of these companies react, this process could be the 2016 challenge for iron ore, were the displaced material to have to be sold in the spot market. In the group’s view, 2Q16 will be the test case here as to how much smarter BHP, Rio and Vale have become around managing supply to the market to underpin prices.
To put the changes in context, compared to Macquarie 2014 forecast, the research group now expects 200 million t less iron ore trade by the end of the decade, which will make any recovery in bulk carrier fleet utilisation (and freight rates) a very, very slow process.
What about thermal coal, number two in the dry bulk demand ranking? Thermal coal prices have already been falling for five years and Macquarie expects further declines. Indeed, the group classes thermal coal as its least preferred commodity exposure. An appropriate analogy might be that being a seller of thermal coal today is probably how it felt to be a seller of wood as coal itself was taking over as the dominant energy source. Or perhaps how it felt being a whaler in the mid/late 1800s as whale oil was almost entirely substituted by kerosene. You know that global consumption has more-or-less peaked; you just are not sure how quick the demise will be.
Europe and the US are shunning coal en masse, while demand expectations for key Asian consumers, previously expected to pick up the slack, are also being revised lower. A global drive towards cleaner energy, collapsing gas prices, falling power intensity of economic growth (under performance of the global industrial sector in general) and increasing power plant efficiency are all key drivers. And if global consumption has more-or-less peaked, the seaborne market, which sets the international price, is doing even worse. It has been in contraction since 2013, due to Chinese protectionism and India being able to supply more of the coal it needs domestically. Speaking of the latter, India provided virtually the only import growth of note in 2015. Yet 2H15 performance was weak and consensus expectations have more-or-less shifted to India having reached peak coal imports.
Perhaps these trend-extrapolated conclusions are premature, considering the scale of Indian infrastructure development required to sustain recent performance. However, domestic coal production is growing more quickly than coal-fired power generation for the first time in years and on top of that, India is now looking seriously at renewables (solar in particular). Considering that Macquarie expects further declines in Chinese imports, on the back of both structural weakness and potentially more protectionism, this is going to mean continued market contraction and the need to displace more supply. This needs to happen in an environment where cost deflation is yet to abate, meaning the US dollar price will need to work hard.
The cuts have thus far been concentrated in Indonesia and Macquarie assumes the market adjustment will continue to come from here going forward. The competitive position of Indonesian coal miners has deteriorated over the past 18 months, with the majority of mining costs being US dollar denominated, government fuel subsidies being removed and efficiency gains being exhausted. On top of that, when looking at ease of cutting supply globally, Indonesian producers are top of the list. As much as 40% of production comes from small private operators, with limited balance sheet flexibility and less burdened by infrastructure and labour-force liabilities. Although exact cost structures are opaque, a relatively safe commodity market assumption is that the more volume needs to be removed, the harder it gets. It now seems inevitable that Indonesian supply will continue to fall, with negative price implications.
The new normal for freight is one where the market has to adapt to not only slower demand, but falling demand y/y. This is over and above the risk of bulk commodity producers facing bankruptcy. As such, the current market problems seem set to be a duration event rather than a blip.