Cashed-up Chinese steel mills are chasing top quality iron ore to help increase output and meet Beijing's tougher environmental standards, driving the premium for high-grade ore to its biggest in two years.

In the latest sign of renewed optimism among China's steel producers as capacity cuts boost steel prices, producers are turning away from cheaper ore with a lower iron content, contributing to growing stockpiles at domestic ports.

The preference will help boost top miners such as Brazil's Vale and Australia's Rio Tinto and BHP Billiton, whose premium quality ore has been taking market share from China's domestic producers.

Iron ore with a 61.5-percent ore grade was trading at a premium of 123 yuan ($18.42) a tonne to 58-percent grade at Chinese ports last week, a level last seen in mid-2014, according to data from industry website Mysteel. (tmsnrt.rs/2bwmHqj)

Chinese steel prices have risen following mill closures and output curbs flowing from an environmental crackdown and Beijing's efforts to tackle a supply gut, buoying mills' profitability. China has promised to slash steel capacity by 45 million tonnes this year.

"We've had pretty good sales over past few months, as steel mills are profitable again since June," said an iron ore trader in Beijing, who sells 65-percent iron ore.

"They like to buy higher grade ore as this can help increase steel output, leading to surging premiums."

A tonne of 61.5 percent ore is currently selling for 445 yuan a tonne at eastern Rizhao port versus 370 yuan for a 58 percent ore.[MYSTL-SIIO-RAYF][MYSTL-IO615-RAF]

Higher quality ores produce more steel for each tonne that is processed, helping to boost output, and can reduce emissions as less coke is used in the production process.

Some mills are also using larger volumes of more expensive lump ore to mix with fines to save on the sintering process, which creates a product that can be used in a blast furnace but is a major cause of pollution, traders said.

In July and August, Tangshan city ordered curbs and some suspensions at sintering and coke plants, which turn coal into a fuel for use in blast furnaces.

David Fuller's view

This is one the better charts of Iron Ore (MBIO62DA Index) as it shows more back history. Quoted in USD, it shows the churning base formation between 2015 and three-quarters of 2016. Iron Ore exploded up out of that formation before consolidating near $80 for several months and then continuing its advance.  I would certainly give the upside the benefit of the doubt, provide Iron Ore remains above $80.

Remember the widespread despair regarding commodity prices in 2015, before they began to recover in early 2016?  This is typical of the late-in-the-cycle bullish moves for industrial resources and also many agricultural commodities.  This is probably no more than another contra-cyclical rebound but I am happy to remain overweight commodities while they remain in form.  Brazil’s Vale, mentioned above, along with Australia’s Rio Tinto and BHP Billiton remain very much in form.  Note: I continue to hold the GBP quoted shares of both Rio and BHP in my personal long-term portfolio.  However, I may commence easing out of these positions when and number of the industrial metals show an overall loss of form.

Meanwhile, recovering commodity prices remain a lifeline for Brazil and will also boost Australia’s much more diversified economy.  Brazil’s IBOV Index remains volatile but it should at least test the 2008 to 2011 peaks.  Australia’s S&P ASX 200 Index remains choppy but it does have an overall upward bias.  Australia’s ASX 300 Resources Index remains in an orderly step-sequence uptrend since its extreme low near 2000 in early-2016.  Watch for an eventual loss of consistency by this Index, although I would not assume that the recovery is over while it remains above the 200-day MA.