By Andy Home
LONDON (Reuters) - Chinese Slowdown is the dominant market narrative for the base metals traded on the London Metal Exchange (LME).
It's why the price of copper, the bellwether of the LME pack, is trundling along in a tight range either side of $7,000 per tonne.
It's why the price of other metals such as nickel and aluminium are now eating into the top end of the global cost-curve.
So why has the price of iron ore, that other great bellwether of the Chinese industrial economy, been rising?
Benchmark 62-percent grade iron ore has spurted higher from its May lows around $110 per tonne to over $130 per tonne.
The rally appears to run counter to the traditional weakness of steel demand across the northern hemisphere, China included, over the summer doldrums.
It is also happening just as the long-anticipated tidal wave of new supply from Australia's Pilbara is starting to build momentum.
How long can the iron ore market continue to defy growing price-negative pressures from both sides of the supply-demand equation?
As ever with iron ore, you don't need to look very far to understand the core driver of the recent rally.
China's leviathan steel sector is still churning out near record amounts of metal.
Production in June was 4.6 percent higher than last year. according to the latest figures from the World Steel Association. Production in the rest of the world fell by 0.6 percent.
China's cumulative production in the first half of this year rose by 7.4 percent, far outstripping any other major steel producer.
The higher-frequency figures from the China Iron and Steel Association (CISA) suggest a bit of seasonal slowdown to an annualized run-rate of 760 million in the first days of July.
But to put that into perspective, that would have been a record in any previous year and is still only marginally off the 800-million run-rate achieved in early March.
China's steel mills are still producing at this accelerated rate because, quite simply, they can still make money.
Margins always hold the key to the Chinese steel sector and right now they are positive.
Shanghai steel rebar futures have risen steadily over the last month with the most liquid contract this week trading at levels not seen since early May.
Leading Chinese steel mills such as Wuhan Steel and Jiangsu Shagang have raised prices for both July and August deliveries.
STOCKS CYCLE SHIFTS
All of which might seem surprising, given that the summer months are traditionally weak months for steel pricing as construction activities slow.
But this is really no more than a swing of the Chinese steel stock cycle pendulum, a reaction to the panic destock of May-June, which rippled up the supply chain to cause a swoon in the iron ore price.
The downside was limited by the fact that iron ore stocks in China were already very low.
The rest of the steel supply chain is now refilling ahead of the expected seasonal pick-up in September, increasing mills' margins and keeping that collective run-rate at a high level.
And since iron ore stocks are still low, China is still sucking up just as much raw material as the rest of the world can throw of it.
Imports rose by 5.1 percent over the first six months of the year. Although June's flow of 62.3 million tonnes was off the pace of the preceding couple of months, it was still 7.1 percent higher than in June 2012.
Attesting to that building wall of supply, though, was the massive jump in imports from Australia, up 16.2 percent over the first six months of 2013 and up an even sharper 25.4 percent in June itself.
SUPPLY WAVE BUILDS
Both Rio Tinto and BHP Billiton are now starting to crank up their Pilbara iron ore operations.
Rio reported a 7.1 percent and BHP Billiton an 11.5 percent year-on-year rise in production in the second quarter.
Rio is lifting output from 237 million tonnes to 290 million tonnes by the end of 2013. That expansion, it said, is running to time with first additional tonnes scheduled by the end of this quarter.
BHP, for its part, is aiming to lift output from its West Australian operations from 187 million tonnes in the financial year through June 2013 to 207 million tonnes in the coming financial year.
It shipped a record annualized 217 million tonnes in the June quarter, implying it is running ahead of its own timetable.
Fortescue Metals, the new kid on the Pilbara block, is moving even faster. Second-quarter production was up by 44.0 percent year-on-year with shipments running at an annualized 120 million tonnes.
A planned expansion to a sustainable production rate of 155 million tonnes is also on time and on budget for delivery in the fourth quarter of this year.
DEFYING THE SLOWDOWN
This supply surge has long been coming and is why just about every iron ore analyst is forecasting lower long-term prices, as cheaper Australian ore displaces high-cost Chinese supply, which defines the top end of the cost curve.
But this is not going to happen overnight and it's not going to cause the iron ore price to implode any time soon.
The far more immediate threat to the recent run-up in prices is going to come, yet again, from China's own steel sector.
Because restocking, just like de-stocking, is a finite phenomenon.
The current restock has caused a significant divergence in the relationship between the country's steel output and its manufacturing activity, shown in the graphic above.
Either manufacturing activity must pick up, and significantly so, over the coming months, or steel production must slow.
Eternally optimistic Chinese steel producers will hope for the former.
And Beijing's "mini" stimulus, centered on micro measures such as accelerated railway spending, might give them some reason for hope, were it not for the fact that more stimulus is only required because of the sharpness of the slowdown elsewhere in the Chinese economy.
More realistically, Chinese producers will have to exercise production restraint once the current restocking impetus fades.
The dip in early-July run-rates may be a sign that this is starting to happen.
But recent history suggests a temporary misalignment of supply and demand in China and a resulting margin squeeze are a more likely base-case scenario.
So how long will the iron ore price continue to defy a slowing growth rate in China?
Keep an eye on local steel prices. They hold the answer.
(Andy Home is a Reuters columnist. The opinions expressed are his own)
(Editing by Anthony Barker)