Do you believe in China?

Recent history
By looking at figures for seaborne trade in coal, iron ore and grain it becomes evident that the surge in imports of iron ore to China has been the prime mover for demand. 10 years ago, China imported about 37.4 mmt of iron ore. 5 years ago, this figure had risen to 55.4 mmt. Thus, during this 5-year period, imports rose by 18 mmt, or 48%. In 2004 we estimate Chinese imports to end at about 203 mmt. In other words an increase of 147.6 mmt, or 266%! Close to two thirds of this increase has occurred during the past two years. No wonder bulk carrier freight rates are so high. Has the rest of the world been at a standstill? Definitely not, however growth in trade in other commodities to other destinations is virtually dwarfed by the growth in trade to China. In the following we will focus on the short-to-medium outlook in Chinese steel production, iron ore demand and the impact on shipping.

Steel Production
The surge in imports of iron ore naturally follows the strong increase in Chinese steel production. During 2002/03, a substantial number of new blast furnaces were built and put into operation. In October 2004, Chinese crude steel output had increased a staggering 22.0% over the preceding 12 months. In addition, steel output actually rose 22.1% over the 12 months period starting in October 2002. Such growth cannot be sustained indefinitely, but the big question is how much will Chinese steel production increase in the next few years and what will the growth profile look like.

Various forecasts
A number of steel companies as well as research institutes have established forecasts for the period 2005-07. The only common denominator in these is that growth will be brisk. One aspect is the growth in crude steel output which is not necessarily compatible with future demand for seaborne iron ore trade. Crude steel output covers blast furnaces (BF), electric furnaces (EAF) as well as steel converters. In all three processes a variable share of steel scrap is used. For the purpose of forecasting iron ore demand, the growth in BF, producing pig iron, is of principal interest.

The better part of this expansion is based on BF technology requiring iron ore and coal. It is interesting to observe that the most upbeat forecast is the one developed by the China Iron and Steel Association at mid-year 2004. Our own forecast was developed early in 2004 and now it looks rather conservative. Our approach when establishing this forecast was to count expansion/replacement projects. By checking each steel mill group about their plans for upgrading/replacement of existing furnaces and plans for expansion we could develop a likely development scenario. There is one flaw with our result, namely the start-up of new projects vs. capacity. If a new BF is due for completion and start-up in February 2005, the nameplate output capacity is not reached in the same month, or even in the next, but it takes some time to gradually build up utilisation and to stabilise processes in order to maintain a desired quality etc. Thus, adding new output by completion date is too simple and leaves an impression of getting capacity into operation at nameplate capacity earlier than in real life. So far this year, we have observed that our forecast is lower than real output. We explain this by accepting that a number of BFs that started during 4Q03 only came to full utilisation in 2004.

By looking at the various forecasts, we see that there will still be a good momentum in the development in Chinese steelmaking capacity in the coming few years. However, from our forecast as presented above, we expect the pace of expansion to slow down after 2005.
 
Iron Ore
As mentioned above, the better part of the Chinese steel making expansion is based on BF technology requiring iron ore and coal. China is more than self-sufficient in the supply of coking coal, however, the country is becoming increasingly dependent on imported iron ore. The domestic output of iron ore has been relatively stable over the past few years (see chart 3), although we saw a respectable increase in 2003. Output ended at 261 mmt which was an increase of about 30 mmt, or 13%, from 2002. This year, however, output is expected to end at 263 mmt. This figure represents an increase of only 2 mmt, or 0.8%.
China has substantial reserves of iron ore, but the biggest problem is quality. First and foremost the ferrous content of Chinese iron ore is quite low, on average about 42% whilst the global average for traded ore is about 62%. This low percentage naturally increases costs and complicates the whole process in terms of having to handle large quantities of waste.

Secondly, Chinese iron ore contains a lot of impurities such as aluminium, silicates etc which all reduce the quality of the iron output from the furnaces. For these reasons, as well as others, the Chinese steelmaking industry has turned to imports. Several of the larger Chinese steelmaking groups are large integrated groups controlling their own iron ore mines within China. From their own presentations of expansion plans we see that they intend to increase mining domestically, however, none of them provide any clear picture on how much they will increase ore output. Rather to the contrary, they state that they actually doubt whether it will be possible to increase output. Our impression is that a maintenance of current output will be considered a success. Thus, we expect all new steelmaking capacity will be fed by imported ore. The chart below shows our expectation for iron ore imports in the coming few years. Our estimate is an increase of 58 mmt in 2005 followed by 23 mmt and 13 mmt in 2006 and 2007, respectively. Metallurgy China, an independent organization engaged in promoting international trade and commerce for metallurgical enterprises, published a survey earlier this year on new steel producing capacity in China. This forecast greatly exceeds our own. Converting the new steel capacity into demand for imported iron ore would exhaust global capacity already during 1st half 2005, and supply would become a serious constraint in the coming few years. By converting BF output to iron ore demand, we could expect Chinese imports to increase by close to 100 mmt in 2005. This will be followed by 40 mmt in 2006 and 23 mmt in 2007. If one considers our forecast as quite optimistic, how do we characterize MC´s ?

Sourcing of iron ore
The majority of Chinese iron ore imports are sourced in Australia, Brazil, and India. This year, however, supplies have been tight and Chinese steel mills have had to turn to rather "exotic" sources including, amongst others, Iran, Liberia, Trinidad & Tobago, and Mongolia, just to mention a few. Roughly two thirds of all traded (seaborne) iron ore is sourced in Brazil and Australia. Exports from these countries are of similar magnitude and each country exports about 16.5 mmt per month. The year-to-date (Oct) average for Brazil is 16.4 mmt (excluding pellets) and 16.8 mmt (Sept.) for Australia. Compared to 2003, Brazilian volumes have increased by 0.8mmt/month and Australian by 1.3 mmt/month. Looking into the "crystal ball", we expect substantial volumes to come into the market from both countries in the years to come. Looking at CVRD´s expansion plans in Brazil, and following a 14 mmt expansion this year, they aim to increase iron ore production by 10 mmt, 44 mmt, and 15 mmt in 2005/06/07 respectively. Following a substantial capacity expansion this year, Australian capacity is expected to increase by about 37 mmt in 2005. In addition, both RSA and India have mine expansion programmes and new mines in West Africa are planned for start-up during the next few years. However, the bulk of new capacity is coming from Brazil and Australia.

Tonnage demand
The current orderbooks for Capesize bulk carriers is basically set for the coming three years. According to Fearnleys´ ship database, a total of 95 Capesize bulk carriers are due for delivery in 2005-07 (120,000 dwt+). In the following comparison between added supply and demand, we have considered developments in China only. For simplicity, we have considered only Australia and Brazil. Naturally, we will see developments in other parts of the world. In this period we will see added demand for iron ore into South Korea as well as continued strong demand in Japan and Europe. On top of this we expect to see a brisk demand for seaborne trade in coal. This development will also provide employment for Capesize bulk carriers. First and foremost for the iron ore trades, but also to some degree as a result of coal trades. (Coal constitutes about one third of all commodities carried by vessels 120,000 dwt+).

A round voyage Brazil-China takes on average about 74 days and a round voyage Australia-China takes about 30 days. Thus, based on normal cargo intake on a 170,000 dwt vessel, it requires 0.59 vessels to carry 1 mmt/year from Australia to China. The comparable figure for Brazil is 1.27 vessels.
If we look at Fearnleys´ forecast for growth in Chinese iron ore imports and assume that China will focus on Australian supplies before Brazilian, we must expect that all iron ore will be sourced in Australia until their new capacity is exhausted before turning to Brazil (for diversification purposes, we expect that the future development will be more balanced, though). When the new capacity in Australia becomes fully exhausted, more iron ore will be sourced in Brazil as long as Chinese demand exceeds new Australian output. According to our calculations, the Chinese steel industry will need 81 Capesize bulk carriers in the coming three years in order to meet the growth in iron ore shipments. During the same period, 95 vessels will be delivered.

Since the growth in demand does not follow a linear trend we will see imbalances between supply and demand during the period. In 2005, we expect balance (one vessel surplus), in 2006, a surplus of 13 vessels, and finally in 2007, a deficit of one vessel.

Discussion & Conclusion
In the above analysis we have simplified the world considerably and the question is whether such simplification results in a  too optimistic scenario. We do not think so. First of all, we have assumed no scrapping. Secondly, we have excluded all other trades which normally would add to the demand for Capesize bulk carriers. Finally, with regard to the heading of this article, if the forecast provided by MC comes true, Capesize demand would virtually skyrocket!
In the coming years, when both ship owners and charterers make strategic decisions on s&p, contracting, time charters or CoAs, they will have to focus on developments in China. The crucial question is: Will China continue to grow at the pace indicated above, or not? Or to put it more concisely, ‘Do you believe in China?´

Sverrr Bjørn Svenning