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What does China's housing sales crash mean for Fortescue?

Problems have been brewing in China’s construction industry since Evergrande defaulted on its debt payments. A 31% fall in new residential housing sales could indicate a rapid slowdown in new construction and steel demand.

China dominates the global steel industry. From just 15% in 2000, China produced 56.7% of the world’s steel in 2020. Steel is 98-99% iron, produced from iron ore. Nearly all the growth in steel demand since 2000 has been from China – mainly in construction.

Since the 1990s, 443 million rural Chinese migrated to the cities. In 2000, 64% of the population was classified as rural and 36% as urban. By 2020 this reversed to 64% being classified as urban and 36% as rural. In a similar period, from 2005-2020, Chinese companies started construction on 18.9 billion square metres of residential housing – the equivalent of 315 million 60sqm dwellings – nearly one per city migrant.

Developers may have started more dwellings than they will be able to sell. As of June 2022, there were 6.07 billion square metres (6,070 square km) of residential floor space under construction – nearly a third of all residential floor space starts from 2005 to 2020.

Developers finance their construction by selling the apartments off plan before building them. The larger construction companies such as Evergrande also tapped international credit markets to finance their land purchases.

Evergrande, China’s largest property developer, eventually spent more than it could borrow and defaulted. The fate of nearly all housing construction is now uncertain.

Plummeting sales

According to the China Daily, for the first six months of 2022, sales revenue for the 100 largest real estate developers fell by 50.3% to 3.06 trillion yuan (US$452.3 billion). This sudden drop in sales revenue could lead to a similar fall in new construction and a significant reduction in steel demand.

So far, iron ore prices have remained relatively strong but for how long?

The future of China’s construction industry

For the first six months of 2022 compared to the same period in 2021:

  • Floor space under construction fell for the second time since 1998, by 3.7%
  • Floor space of houses newly started fell by 36.1%
  • Land acquisition area – a leading indicator of future construction – fell by 48.1%.

What does a potential crash mean?

The potential crash of China’s construction industry could remove 15% of iron ore demand from the market.

China’s construction industry uses around 2/3rds of China’s steel production – around a third of global production. So whatever happens to the Chinese construction industry happens to steel demand. A reduction of 48% could convert to a 30% decrease in China's steel demand and a 15% decrease in global iron ore demand.

China’s slowdown: early stages

According to the official statistics of the China Iron and Steel Association, for the first six months of 2022, steel demand in China is only down 6.4% as the average daily output of steel in July fell by 13.1% from June.

Fortescue's future?

Fortescue Metals Group Ltd is the world’s fourth-largest iron ore producer and had a market valuation of $A53 billion as of 20 September. It was also growing rapidly until this year. Between 2018 and 2021, Fortescue’s revenue grew more than 3x from A$6.9 to A$22.2 billion and profit soared more than 10-fold over the same period to A$10.3 billion.

However, on 29 August Fortescue announced a 40% fall in profit for the year ended 30 June 2022. Fortescue shares fell by 17% in the five days following this announcement. The 40% lower profit was earned at an average iron ore price of US$99.80 per ton – 26% lower than the previous year. This may be just the first move.

If the above assumptions and analysis are correct, and if steel demand continues to fall, a bet on a falling iron ore price or falling Fortescue stock price could reap a handsome reward.

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