Iron ore and coal price gains may be premature 

(MENAFN - Arab News) Any time the prices of commodities rally on the hope that something positive will happen rather than any actual change in fundamental demand, there is the risk of disappointment.

This may well be the case with iron ore and coal, both of which have gained recently in Asia on the hope that China will successfully stimulate its economy, thereby boosting demand.

Spot iron ore posted its biggest one-day gain on record on Monday, jumping more than 6 percent to 95 a ton.

This followed China's approval of 150 billion in infrastructure spending and August trade data that showed imports of the steel-making ingredient rose, defying expectations of a decline.

Spot coal at Australia's Newcastle port has also rallied off its recent lows and may gain further this week on the back of the Chinese stimulus announcement.

Coal posted a small gain to 91.73 a tonlast week, having gained from the 2012 low of 84.98 hit in late June.

It's no surprise that traders have bid up prices on the hope that China will once again ride to the rescue of commodity demand as it did after the 2008 global financial crisis, but it would seem that this time there are more reasons to be cautious.

What's different between now and 2008 is that the size of the stimulus is going to much smaller, and probably more carefully managed over a longer period of time.

This means that while demand may well increase for base metals and coal, it's unlikely to post rapid gains.

The other main difference is that inventories are higher as it's only very recently that commodity producers and consumers finally recognized that demand had been weakening and was unlikely to rebound quickly.

This is particularly true in iron ore and coal, with China's stocks of imported iron ore holding close to 100 million tons, not far from the record 101 million tons recorded in February this year, and power stations are also reported to have plentiful coal inventories.

When there is a large overhang of supplies, it will generally take longer to work through them even if demand does pick up.

However, there are also reasons to believe that the worst may be over for iron ore and coal prices, even if hopes of a sustained price rally may be a touch optimistic.

It appears that the supply response to lower prices is finally happening, with miners lowering output.

While the big three iron ore miners, Brazil's Vale, Rio Tinto and BHP Billiton haven't trimmed output, it appears that the high-cost smaller, privately owned producers in China have.

Domestic iron ore output in China is dominated by large, state-controlled firms that are unlikely to cut production much as maintaining employment is viewed as more important than producing profits.

However, the smaller players, many of whom have costs above 100 a ton and are therefore loss-making at current prices, have little option but to shutter production.

Domestic iron ore output rose slightly in August from July, but was down strongly from June's level, and the expectation is that it will start to decline more sharply from this month onwards.

August output was 116.57 million tons, while July's was 115.46 million tons and June's 125.69 million tons.

Based upon what happened in 2009 when prices were also below 100 a ton, as much as 30 million tons a month of Chinese domestic output could leave the market.

This would allow for import volumes to remain strong, but for so long as prices remain low enough to keep private domestic mines out of the market.
It's much the same story for coal, with the Newcastle price currently below the domestic Chinese price, although the gap has narrowed recently.
Coal supply has also been leaving the market, with BHP announcing this week it would cease production at its Gregory mine in Australia's Queensland state.

Rio Tinto and Xstrata have also recently announced cutbacks in Australia, while producers in Indonesia, the biggest exporter of thermal coal, have also been trimming output.

The Indonesian Coal Mining Association last week cut its 2012 production forecast to between 340 and 350 million tons, down from an earlier estimate of 390 million tons. The belated cuts in supply will eventually work to balance the market, but, similar to the Chinese stimulus spending, it's unlikely to be a quick fix.

- Clyde Russell is a Reuters market analyst. The views expressed are his own.