As the price for iron ore drops, the relative cost of freight increases. Previously, we saw potential support in looking at this historical correlation when freight cost for iron ore out of Australia and Brazil amounted to c5% and c10% of the commodity price. As prices tumble the implications have flipped, with the freight element now at 14% and 30% of the commodity compared to the historical average of 8% and 19%.

Reportedly, China aims to limit crude steel production close to 2020 levels in a stated effort to reduce pollution. If pig iron production (+80% of steel production) is capped at last year’s 887.5 MMT, we estimate that the last four months of 2021 would see an average production of roughly 71 MMT, which is down 5.7% YOY and would negatively impact China’s near-term iron ore demand. In our view, China’s recent curb of steel production could be linked to high energy prices and power rationing ahead of rising demand in the winter months. This view is supported by reports citing a state-run Chinese newspaper claiming that coal-fired power plants could struggle to keep the lights on this winter. YTD, China’s thermal electricity production (+70% of total production) is up 13.7% while coal production is up 6.0%. In turn, this has led to rising coal prices as imports only account for a fraction of China’s consumption. Limiting steel production would therefore alleviate some pressure on domestic electricity production given the segment’s relatively high energy intensity.

Consequently, should China limit steel production for the remainder of 2021, iron ore would be negatively impacted but could be partially offset by rising coal imports ahead of peak demand. We remain optimistic on the long-term prospects in the sector, and we view short term headwinds providing a more attractive entry point for investors who missed on the bull run year-to-date.