CHINA STEEL SECTOR:INVENTORY BECOMES MORE WORRYING;TIMING OF CAPACITY CUT MATTERS

High inventory caused by resilient production, low demand and exports

Daily crude steel production at large and medium (L&M) mills slightly declined 0.2% ona 10-day basis to 1.62mt (up 7.6% YoY) during the last 10 days of Jan-17, according toChina Iron and Steel Association (CISA). Total production rose to 2.24mt, implying818mt annualised (up 12.2% YoY). Inventory at L&M mills further jumped to 14.1mt asof 31 Jan-17 (up 17.7% YoY), marking a four-month high. We expect production toremain very resilient (Rmb134/t cash margin for rebar as of 10 Feb-17) and inventory tocontinue rising in the short term as a result of slowing demand and low exports.
Two-year high inventory level at traders

Steel products inventory at traders rose 17.1% WoW and 72.8% YoY to reach 15.7mtas of 10 Feb-17, which is the highest since Mar-15 (source: CISA). We attribute theinventory stack-up at traders to current seasonal low demand and preparation forexpectedly high demand in Q217. If the demand in Q217 is strong in fact, we could seefurther upside for steel prices; however, if demand turns out to be weak, steel pricestend to decrease due to destocking pressure. So far, we do not have high visibility ondemand, especially in Q217 (peak season for demand).

Major capacity cut to occur in H217E rather than in H117E

We estimate 90mt of steel capacity was cut in 2016 (planned 45mt). Due to stricterenvironmental protection measures, we expect capacity cut to be 50mt in 2017 (4.5%of the total capacity as of 2016). However, we expect the major capacity shutdown tooccur in H217 rather than in H117. That said, we could see supply to be very resilient inQ217. If demand in Q217 misses market expectations, the downside pressure of steelprices could be hefty amid high inventory.
Valuation: maintain Sell on Angang Steel and Maanshan Iron & Steel (Magang)

We do not expect any long-term structural investment opportunities in the China steelsector. We maintain our Sell ratings on Angang and Magang.

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