Kevin Frayer/Getty Images

Iron ore prices have fallen heavily in recent weeks, especially for higher quality, higher cost grades.

Chinese steel mill profitability has collapsed, falling to the lowest levels since May last year.

With margins being squeezed, it could lead to weaker iron ore demand and prices.

Iron ore markets have staged a fairly dramatic turnaround in recent weeks with prices across all major grades falling sharply from mutli-month or multi-year highs struck earlier in the month.

According to data from Metal Bulletin, the price for 58% and 62% benchmark fines both hit one-month lows on Thursday, extending the drop from their recent highs to 6.5% and 5.9% respectively.

For more expensive, higher quality ore the drop has been even more acute with the price of 65% fines sliding 8%, leaving it at a five-month low.

This chart from the Commonwealth Bank explains why prices have suddenly started to fall: Chinese steel mill profit margins have collapsed, falling to the lowest level since May 2017.

Commonwealth Bank

While higher costs for raw materials have contributed to the steep and sudden decline, Vivek Dhar, Mining and Energy Commodities Analyst at the Commonwealth Bank, says the main factor has been continued falls in steel prices.

“Chinese steel mill margins have dropped sharply in recent weeks, primarily driven by lower steel prices,” he says. “[This is] in stark contrast to the profits the sector has enjoyed over the last 18 months.”

Given how fast margins have been eroded, Dhar says it raises questions as to whether prior attempts to improve profitability across the sector by shuttering obsolete or illegal mills can be sustained over the longer-term.

“While we always suspected margins needed to moderate from their late-2017 levels, we expected the decline to be longer and more gradual. But our current reality raises the question of whether China’s steel sector has changed structurally,” he says.

While Dhar thinks a period of prolonged margin weakness is unlikely, he says the recent collapse is likely to influence iron ore prices in two phases.

“First, low margins will see steel mills prioritise affordability over productivity and emission reduction,” he says.

“That will see mills move to low grade ore, a trend that has already resulted in mid-grade and high-grade iron ore premiums falling.

“Second, low margins will discourage steel mills to produce.”

And with lower production comes the prospect of weaker demand, and hence lower prices.

“Subdued steel margins will eventually mean weaker iron ore and coking coal prices as mills struggle to stay afloat,” Dhar says.

Business Insider Emails & Alerts Site highlights each day to your inbox. Email Address Join

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.