Scrap Steel On The Rise: Drivers & Implications


BMI View: China's steel industry will gradually move towards EAF-based steel production in the coming years as the advantages of using scrap steel are enhanced by the green push and economic slowdown in the country . Apart from being much less polluting, Chinese demand for scrap steel will be driven by the desire to reduce dependency on seaborne supply , as well as the growing importance of arresting the precipitous fall in smelter margins since 2009 . The ongoing shift towards EAFs will create ripple effects across several industries, notably, the iron ore, coking coal and shipping sectors.

We expect scrap steel to gain increasing popularity as a feedstock for Chinese steelmakers over the coming years as Beijing's push to curb environmental pollution gains traction. As spotlighted by a parade of mill closures in recent months, China's steel industry is taking the strain of tighter environmental regulations aimed at reducing toxic smog that hangs over parts of the country. According to the Ministry of Environmental Protection, seven of China's 10 most polluted cities are located in Hebei, the country's largest steel-producing region accounting for a quarter of China's steel. Indeed, Hebei's capital, Shijiazhuang, routinely posted 'beyond index' measurements of particulate matter (PM) in early 2013.

As scrap steel gain popularity as a feedstock, a growing number of Chinese steelmakers will gradually shift towards Electric Arc Furnace's (EAF) production (where scrap steel is turned into molten steel) over the coming years. This will represent a shift from blast furnaces that currently dominate the landscape of the Chinese steel industry, and by extension, the global steel sector.

EAF To Gain Traction In China
Steel Production - By Furnace Type (LHS) & By EAFs (RHS, as % share of total production)

Drivers

First, the heavy use of scrap steel in EAFs significantly reduces the amount of iron ore and coking coal required for steel production. As a result, EAF-based steel production is generally more energy-efficient and environmentally-friendly compared with the traditional Basic Oxygen Furnace (BOF). On average, the use of scrap steel in steel production helps to lower energy consumption by over 60% for every tonne of steel produced. Unsurprisingly, the Chinese government has explicitly stated its support for scrap steel consumption in the country's 12 th Five-Year Plan (2010-2015), aiming to increase the amount of scrap in steel production from 15% at present, to 20% by 2015.

Table: Details of Steelmaking Furnaces by Type
Raw material Energy source Products
Basic Oxygen Furnace (BOF) Iron ore and scrap Coke Carbon steel and low-alloys
Electric Arc Furnace (EAF) Scrap Electricity High-end carbon steel and alloys
Open Hearth Furnace (OHF) Scrap, iron ore and flux Gas and oil General products
Advantages Disadvantages
EAF Less energy-intensive Requires investment into systems such as dust collectors to limit environmental footprint
Significantly reduce carbon emissions Constant power supply is vital
Greater operational flexibility; production can be quickly adjust to meet demand
Lower construction cost
Source: News sources, BMI
Table: Raw materials & energy consumption/emissions associated with one tonne of crude steel production
BOFs EAFs
Inputs
Iron ore, kg 1,725 0
Coking coal, kg 645 65
Scrap steel, kg 138 1,050
Electricity, gigajoule 23.3 9.6
Outputs
CO2, kg 3,000 800
Dust, kg 300 60
Source: WSA, Mysteel, Standard Chartered Research

Second, Chinese demand for scrap steel will be driven by the desire to reduce reliance on raw materials from the seaborne market. Crucially, the price volatility associated with seaborne iron ore has emerged as a flashpoint for disputes between China and overseas miners on several occasions. In 2013, China's National Development & Reform Commission (NDRC) lashed out at major iron ore miners - Brazil's Vale and the Australian pair of Rio Tinto (Rio) and BHP Billiton (BHP) - for allegedly artificially pushing up the prices of seaborne ore by holding back supplies. While facts on this are thin on the ground, it certainly highlights the resentment present in China over the concentration of market power enjoyed by the big three miners (which, together, accounted for around two-thirds of the global iron ore trade in 2012). In a bid to enhance the country's pricing power in commodities, Chinese authorities have been making bold strides in the establishment of domestic-based commodities futures contracts ( see 'China's Commodity Futures On The Ascent', November 05, 2013) .

Ore-Some Increase
China - Iron Ore Imports

Furthermore, the sharp decline in the grade of Chinese-mined iron ore over the past decade implies that China will remain hostage to seaborne supply, unless efforts to reduce iron ore consumption reach fruition. The average grade of marginal Chinese iron ore has reportedly fallen from 43% in 2004, to 15% in 2012. Subsequently, many miners are adopting more complex and expensive processing methods, with energy becoming a larger overall constituent of the cost structure. This has placed China at the top end of the global iron ore cost curve, at around US$120/tonne, in contrast to US$30-50/tonne for major miners in Australia and Brazil.

High-Cost Chinese Tonnage
Global - Iron Ore Cash Costs By Company (US$/tonne & Production As % Capacity)

Third, the cost-efficiency associated with EAF steel production should help Chinese steelmakers to partially arrest the precipitous fall in smelter margins since 2009. Indeed, falling steel prices are squeezing Chinese steelmakers' profit to almost non-existent for the whole industry and a growing number of them are diversifying into non-steel businesses such as technology, real estate and pig farming in recent quarters. The gradual embrace of free market economics by Beijing's new leaders should thus, embolden the push towards EAFs as cost-competitiveness becomes increasingly important with the downshift of the Chinese economy.

Profit Crunch
Price Ratio: China Steel Rebar/Iron Ore Import Price

Implications

The growing shift towards EAFs, hence, scrap steel consumption, will have knock-on implications on several sectors. Specifically, the iron ore and coking coal sector s will suffer from falling Chinese demand over the medium term. Indeed, each tonne of steel produced using EAF does not consume any iron ore and requires only 65kg of coking coal. In contrast, steel production through BOF requires 1.7 tonne of iron ore and 645kg of coking coal. This will adversely impact the fortunes of major miners such as Rio and BHP, which are betting on continued demand growth from China to fund their iron ore expansion projects in Pilbara, Australia. We believe it is almost impossible for other countries to replicate the China-led commodities boom over the past decade, and the excess weight of seaborne ore caused by the pullback in Chinese demand could be a significant drag on prices in the coming years.

Additionally, the dry bulk shipping sector, which is still licking its wounds from the global financial crisis, will feel the pain of falling rates due to declining appetite for coal and iron ore in China. Of critical importance, iron ore is the largest dry bulk commodity and China accounts for around two-thirds of global imports.

On The Hook
Baltic Dry Index (USD)

On a positive note, we acknowledge that the operational flexibility of EAFs could alleviate the problem of overcapacity in China's steel sector as domestic producers can better adjust output according to market conditions. In contrast, BOFs are unable to alter their production much and generally run for years at a time. While the absence of a carbon tax has partly concealed the cost advantage of using EAFs in the past, this is set to change with the start of pilot programs for carbon pricing schemes in China last year. No doubt, the Chinese government is gradually coming to grips with the deleterious impact of environmental pollution and has undertaken a spate of measures aimed at slashing carbon emissions over the past quarters.

The various dynamics at play make it difficult to forecast the outlook for Chinese scrap steel prices. On the one hand, growing demand for scrap steel would almost certainly drive up prices over the medium term particularly with the Chinese government bringing down the hammer on imports of scrap materials. In 2013, the 'Operation Green Fence' campaign was launched by Chinese customs to enforce laws governing the inspections of scrap imports at domestic ports. It was reported that more than 800 thousand tonnes of 'illegal waste', including anything from impure bales of plastics, paper to metal scraps, has been intercepted over a four-month period.

Conflicting Forces At Work
China - Average Scrap Steel Prices (US$/tonne)

On the other hand, expanding supplies of scrap steel in the Chinese market could easily counter the price-supportive impact of higher demand. China, the world's largest shipbuilding nation, announced in late 2013 that it will increase cash subsidies for scrapping obsolete ships by 50% in order to tackle overcapacity and carbon emissions. Under the new program, ship operators will received half the money upon completing scrapping and the remaining after placing new building orders.

This article is tagged to:
Sector: Mining, Metals
Geography: China, China, China, China