(The opinions expressed here are those of the author, a columnist for Reuters)
By Andy Home
LONDON, Feb 14 (Reuters) - Here we go again?
The price of iron ore traded on the Dalian Commodity Exchange (DCE) rose on Tuesday for the sixth consecutive day and is now at its highest level in three years.
The paper market is pulling the physical market higher.
Iron ore for delivery to China's Qingdao port .IO62-CNO=MB jumped 6.5 percent to $92.23 a tonne on Monday, the highest since August 2014, according to Metal Bulletin.
It's a rally that appears illogical given what should be a bearish cocktail of rising supply and swingeing cuts to Chinese steel capacity.
We've been here before of course.
There was a similar spike in Chinese ferrous futures prices almost exactly a year ago as speculators piled into domestic markets before being beaten back by a combination of trading and margin fee increases.
So is this a return of last year's speculative bubble?
Graphic on Dalian Iron Ore - Price, Market Open interest and Volume: tmsnrt.rs/2lFgC3l
A comparison of the market mechanics of the Dalian iron ore contract now and a year ago, shown in the graphic above, is instructive.
Volumes are nowhere near the extreme levels seen over the first and second quarters of 2016.
Even with a noticeable pick-up into the current price rally total volumes have averaged 1.43 million lots per day so far this year. At the peak of last year's frenzy, in April, daily volumes were averaging 6.63 million lots.
Market open interest has also increased as the rally has extended but, again, at a current 1.547 million lots, it is some way short of the two-million-plus levels seen over the course of late February and March 2016.
Quite evidently, the army of retail investors, many of them day-traders, has not returned to the iron ore fray in the same numbers as last year.
That's not to say there aren't speculative forces at work but they are qualitatively different this time around.
Graphic on China's real estate investment 2013-2016:
Graphic on China's steel production:
The irony is that although last year's price rally, not just in iron ore but also in steel futures, was collectively chaotic, it was a good bet on the state of China.
Chinese investors read Beijing's policy shift faster than the outside world.
Even as the world's biggest iron ore producers were still lamenting the death of the so-called "supercycle", China's policymakers quietly reversed their pledge to move away from a metals-intensive fixed asset investment model towards a more consumer-orientated growth template.
Faced with sharply slowing economic growth rates, they did what they had done before, pumping money down the twin channels of infrastructure and construction.
Total investment spending on real estate, one of the key drivers of steel usage, had been steadily slowing over the course of 2015 but it re-accelerated again from the start of last year.
That, with hindsight, was the buy signal for both steel and iron ore.
It took only a couple of months for China's steel mills to respond to the renewed stimulus.
After contracting by almost three percent in 2015 national output returned to positive year-on-year growth in March last year with full-year 2016 production up 1.2 percent.
The impact on iron ore pricing was magnified by a reduction in domestic output with smaller operators closing during the weak price environment of 2015.
And right now the macro indicators of underlying steel demand remain positive.
Real estate investment grew by 6.8 percent year-on-year in December. Steel production grew by 3.2 percent.
But what about all those Chinese steel capacity cuts, I hear you ask?
Beijing closed something like 85 million tonnes of excess steel production capacity last year, the first instalment of a five-year target of 150 million tonnes.
In doing so it was responding to both international and domestic pressure in the form of push-back against rising Chinese steel exports and worsening pollution levels in its cities.
But here's the thing.
Much of what was "cut" hadn't been operating in the first place. The impact of all those closures on actual productive capacity may have been as little as 23 million tonnes, according to research by the unlikely combination of Greenpeace and Custeel, a consultancy affiliated with the China Iron and Steel Association.
Indeed, the key conclusion of the report is that rather than contracting, China's effective steel capacity grew by a net 36.5 million tonnes as producers responded both to improved demand and better margins.
Which seems counterintuitive but isn't.
The sector is still bloated but a lot leaner than it was a couple of years ago. Which means it will run faster when given the right pricing incentive to do so.
And it's running faster because last year's stimulus is still keeping key demand sectors such as construction running faster.
All of which is good news for iron ore usage.
Which is not to say that the iron ore price is simply going to keep motoring. Nothing, as the old market adage says, moves in straight lines.
One warning sign is the steady rise in Chinese port inventories, which suggests that even with positive demand growth from the steel sector, the country is struggling to absorb supply from the rest of the world.
That little problem is only going to get worse if China's own iron ore producers start reactivating mothballed capacity, which at current prices must be tempting.
Moreover, nobody expects Beijing to keep pumping stimulus into the economy for ever.
A slowdown will inevitably come at some stage.
The key question then is whether China's steel sector will be able to respond in a timely and efficient manner. If it doesn't, we could see a repeat of the sort of disorderly destocking cycle that has sent the iron ore price plummeting in the past.
The trigger for any turnaround might not be immediately obvious to the outside world but, on past form, expect the Chinese investment community to respond quickly.
Exuberant it may be. But that doesn't make it irrational.
Editing by David Evans