* Steel mills' operation rates and market inventories running low
* Short-term iron ore demand may rise on higher China steel output
* However, 2016 full-year China steel capacity likely to contract (Updates close prices)
SHANGHAI, Jan 19 (Reuters) - Chinese iron ore futures rose for a third session to hit a nearly two-week high on Tuesday as a recovery in Chinese steel prices because of low metal inventories and a contraction in Chinese output supported the raw material.
Steel mills in China, the world's top producer, have slashed output after prices tumbled to record lows. In December, production dropped to 64.37 million tonnes, down 5.2 percent from a year ago. Full-year output fell 2.3 percent from a year ago to 803.8 million tonnes, the first drop since 1981. Chinese inventories of five main steel products slumped 16.7 percent from a year ago to 8.67 million tonnes by Jan. 15, data from industry consultancy Custeel.com showed, as mills curbed output and traders were reluctant to stock.
The most-traded iron ore contract on the Dalian Commodity Exchange DCIOcv1 surged 2.6 percent to 322 yuan ($48.94) a tonne by close. It earlier rose to 323.5 yuan a tonne, its highest since Jan. 6.
The benchmark rebar contract on the Shanghai Futures Exchange SRBcv1 rose to a session high of 1,841 yuan a tonne, its highest in two weeks. It closed 1.8 percent higher at 1,839 yuan a tonne.
"Inventories of steel products are running very low and mills' utilization rates are falling quickly. So there is room for steel production to recover a bit and support iron ore," said Yu Yang, an analyst with Shenyin & Wanguo Futures in Shanghai.
Though, full-year 2016 steel production is expected to fall further as the Chinese government is determined to erode overcapacity in steel industry and allow inefficient firms to shut down.
Despite a steep slide in iron ore prices and slowing demand from the world's top consumer, global miner Rio Tinto RIO.AX RIO.L plans to increase iron ore production and shipments in 2016, taking advantage of its position as the world's lowest-cost producer. the world's second-biggest iron ore producer, reported that 2015 iron ore shipments were 336.6 million tonnes, an 11 percent increase from 2014. The company plans to ship 350 million tonnes in 2016, including its mine co-owners' volumes.
Iron ore for delivery to China's Tianjin port .IO62-CNI=SI rose for a third day, rocketing 4.2 percent to $41.90 a tonne on Monday, a level last seen on Jan. 6, according to The Steel Index.
Rebar and iron ore prices at 0705 GMT
Contract
Last
Change Pct Change
SHFE REBAR MAY6
1839
+32.00
+1.77
DALIAN IRON ORE DCE DCIO MAY6
322
+8.00
+2.55
SGX IRON ORE FUTURES FEB
41.65
+0.15
+0.36
THE STEEL INDEX 62 PCT INDEX
41.9
+1.70
+4.23
METAL BULLETIN INDEX
42.66
+1.54
+3.75
Dalian iron ore and Shanghai rebar in yuan/tonne
Index in dollars/tonne, show close for the previous trading
day
($1 = 6.5792 Chinese yuan renminbi) ($1 = 6.5793 Chinese yuan renminbi)