The mainland's iron and steel sector is once again under the Hong Kong stock market's spotlight. Media reports that steel furnaces are being shut down in Hebei province this month by local governments, in a bid to cut power-usage by energy-intensive industries, is having an effect.

With furnaces being shut from 20 to 30 days, long steel supplies are the most likely to be affected. As such, steel prices in Hebei province rose by 100-400 yuan a metric ton over the weekend. But I would like to share some views from a more macro perspective.

First of all, let's take a look at the raw material. Rio Tinto, the world's second largest iron ore miner, stated that its iron ore FOB (free on board) contract price would fall 13.3 percent quarter-on-quarter in the fourth quarter of 2010 to $127 a ton in accordance with a proposed new mechanism starting in the quarter based on the average index price during the third quarter of 2010.

Although Chinese steel mills have yet to receive any notification or confirmation from the three leading iron ore miners, the market certainly expects it to follow the downward trend of iron ore prices. On the other hand, Vale, the largest iron ore miner in the world, has announced it will introduce a price cut of 10 percent in October for the fourth quarter of 2010 to $134 a ton due to weak demand from Chinese steel mills in the past five months. The contract price is on par with the current China-imported iron ore FOB price of $135 per ton.

By the same token, however, we do not see decreasing prices as a sustainable trend going forward. Judging from the sharp rebound in the spot price trend of 17 percent in the past month, we expect global miners to raise their contract prices again for the first quarter of 2011. Iron ore imports also rebounded for the first time in July (up 9 percent month-on-month) since March, which we believe was due to the completion of repairs at some large steel mills. They also used up their iron ore inventories, which are usually sufficient for one to two months of consumption. We expect imports to continue to rise in the next month, supporting higher iron ore prices. However, we don't expect a sharp rebound as growth is likely to be capped through the accelerated elimination of outdated capacity. This is because the government is striving to meet its energy savings target before the end of the 11th Five-year Plan.

While we expect the industry glut to persist for a few more years, we also think the gap will narrow given the effectiveness of the consolidation efforts so far and an increased sense of urgency on behalf of the government. During full-year 2009, China shut down 16.9 million tons of obsolete steel capacity, representing 2.4 percent of the nation's total steel capacity and 6 percent of its inefficient capacity. This was well above its target of 6 million tons. During the same period, around 21 million tons of iron-making capacity was shuttered; double the targeted 10 million tons. New supply should be restrained, as other than the 58 million tons of new capacity (9 percent of existing capacity) already approved, many large-scale expansion projects have been suspended including Baosteel's and Wuhan Steel's 10 million-ton projects.

On the supply side, we project 710 million tons of crude steel capacity by the end of full-year 2010, with an annualized crude steel production of 640 million tons. For full-year 2011, we expect capacity to rise to 712 million tons, after factoring in the government's elimination target of 20 million tons. While oversupply should persist into next year, we project it to narrow from 174 million tons this year to 165 million tons next year. And a more obvious correction should be realized in full-year 2012 after a longer period of new capacity approval suspensions and outdated capacity elimination.

Overall, we believe the chances of another round of massive steel capacity closures for the purposes of energy conservation are relatively low. Besides, industry consolidation and outdated capacity elimination will remain long-term trends, which should benefit large plays. Moreover,in our view, valuations for many steel companies are still reasonable.

Peter Pak is Executive Director of BOCI Research Limited. The opinions expressed here are entirely his own and do not represent BOCI or any other affiliated companies within the group. Nothing in this article constitutes an investment recommendation.

(HK Edition 09/15/2010 page2)