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COLUMN-What's 40 million tonnes of Chinese steel between friends?: Andy Home

(Repeats Sept. 11 item. The opinions expressed here are those of the author, a columnist for Reuters.)

By Andy Home

LONDON, Sept 11 (Reuters) - BHP Billiton (NYSE: BBL - news) last month revised downwards its forecast of "peak steel" production in China, the world's largest producer of the stuff.

It (Other OTC: ITGL - news) will happen, BHP said, some time in the mid-2020s and the peak will be between 935 and 985 million tonnes, or 960 million in the middle of that range.

Rio Tinto (LSE: RIO.L - news) , by contrast, is sticking with its call that the peak will come around 2030 and will be around one billion tonnes.

BHP's shift of stance grabbed a lot of media coverage. After all, these are two of the world's largest producers of iron ore and China is the world's largest buyer of their product.

For BHP and Rio and their shareholders "peak steel" in China is more than just an academic talking-point.

When it comes and at what level will determine whether the two Pilbara producers have been right to keep building out new iron ore capacity.

But the real significance of these "peak steel" forecasts is not the relatively small 40-million tonne gap that has opened between the two companies but what they still have in common.

Both are still taking a benign view of China's industrial economy, one in which the current slowdown is merely a blip in the longer-term trend.

It's a view that contrasts starkly with the current doom and gloom pervading just about every industrial commodity, several of which are trading at levels last seen during the Global Financial Crisis.

If they are right, the current negativity about China is overdone, the markets misreading the necessarily messy transition from investment- to consumer-driven model, a process dubbed the "new normal".

If the markets are right, however, Rio and BHP are going to be taking a lot more criticism for their "saturate and dominate" approach to iron ore supply.


Chinese steel production is not growing at all right now. Cumulative output was 476 million tonnes in the first seven months of 2015, down by 1.8 percent on last year's equivalent level.

It's the first time Chinese steel production has actually contracted in more than a decade and follows a warning in January by Zhang Guangning, chairman of the China Iron & Steel Association, (CISA), that "China's steel sector has already entered a period of peaking and flattening out".

To which Rio's response, or rather that of its head economist Vivek Tulpule, is that "it is important to see through near-term volatility and cycles" when "looking at long-term trends".

Tulpule was speaking at Rio's investor presentation in Sydney earlier this month and chose the occasion to launch a detailed defence of the company's contention that "peak steel" in China is still a long way off.

His presentation, available on Rio Tinto's website, is both a fascinating insight into the group's forecasting methodology and full of interesting snippets.

Such as a projection that by 2030 nearly 25 percent of China's current urban residential building stock will be demolished and rebuilt, one- or two-storey buildings being replaced by higher rise structures needing more steel.

The key takeaway, though, is that Chinese steel production will continue growing to 2030, albeit at an annual average rate of just one percent, compared with the booming 14 percent of the previous 15 years.

In other words, slowdown and a sharp one at that, but not actual contraction and certainly not the end of the China growth story.

BHP in essence agrees, even if its view is that Chinese steel production is not going to be quite so strong for quite so long.

It hasn't lifted the bonnet on its research engine in the same way as Rio Tinto but, according to Chief Executive Andrew Mackenzie, speaking to analysts at the time of the company's first-half results, "we redo our forecasts bottom-up, in incredible detail, every six months".

And those forecasts, positing "peak steel" a decade in the future, are, Mackenzie said, "a realistic view".


There are plenty of others who would take issue with such a rose-tinted view of China right now.

Analysts at Goldman Sachs (NYSE: GS-PB - news) , for example, have argued both that the slowdown in China's industrial activity has been harder than suggested by the official macroeconomic figures and that demand for all metals will continue to suffer from a longer-term debt deleveraging cycle that has only just begun. ("Revealing China's commodity 'hard landing'", July 20, 2015).

Only time will tell who is reading China right, particularly given the number of moving parts in the equation, each and every one of them subject to a host of known unknowns.

But missing from Rio and BHP's bottom-up analysis of steel demand drivers in China is the issue of overcapacity in the country's steel production sector.

Industrial overcapacity is "the largest problem facing the Chinese economy now," according to Xu Shaoshi, chairman of powerful state planning body the National Development and Reform Commission (NDRC).

And much of that excess capacity is in the steel sector, where it is manifest in razor-thin margins, poor profitability and bombed-out local steel prices.

Overcapacity means inefficient markets, steel-mills over-producing relative to demand just to generate cash flow and service debts with all the accompanying risks of violent destocking events and mini debt default chain reactions.

It also exposes the steel sector to direct government intervention in the form of enforced capacity closures, such as have been taking place on environmental grounds in areas surrounding smog-plagued Beijing.

Steel production may indeed grow at an average rate of one percent over the next 15 years but such a smooth long-term projection may mask high levels of what Rio's Tulpule terms "volatility".

There is a direct analogy here with that other plank of iron ore producers' thinking, namely that their lower production will displace higher cost production, forcing the market to rebalance.

Such a belief in the efficiency of the iron ore market is why the consensus view was that the price wouldn't fall below $90-100 per tonne. Until, of course, it did.

Reality has a nasty habit of not being as efficient as theory says it should be. Higher-cost producers may not meekly accept their fate but will rather struggle on. Costs themselves are a moving target and right now they are falling as commodity price weakness feeds into a vicious circle of cost deflation.

The iron ore displacement cycle has already proved to be a lost messier than expected, which is why, even after the recent rally, the price is currently still struggling below $60 per tonne.

After underestimating the inefficiency of the iron ore market, there is a similar risk of ignoring the even greater inefficiencies of the Chinese steel market.

It's not the contrast between Rio and BHP' views of "peak steel" that is important. After all what's 40 million tonnes or so between friends?

It's the widening gap between their collective view of China and that of most other commentators right now that is the real stand-out.

(Editing by Susan Thomas)

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