The arrests of Rio employees in China on corruption charges and their subsequent convictions at the end of March have made the issue of iron ore pricing particularly topical in some sections of the financial media. But, market practitioners were expecting changes several months earlier, as the benchmark pricing mechanism for one of the world's leading commodities had become increasingly untenable.
Differentiated pricing derived from the spot price, itself determined by supply and demand, has replaced a 40-year-old system based on annual contracts that was increasingly causing frustration to producers and was being circumvented by consumers when it suited. The new, market-based arrangement is expected to lead to a rapid expansion of a derivatives market that is still in its infancy.
Over the past decade the supply-demand equilibrium for iron ore has broken down, largely due to China's insatiable appetite for iron ore to fuel its industrialisation. China accounted for 17% of seaborne demand in 2000; by 2009 its share was 70%. The result has been increased price volatility, which is one reason why the old annual benchmark system became unsustainable.
The transformation of iron ore prices "started as a puddle, which developed into a reservoir, which then burst the dam", said Ray Key, global head of metals at Deutsche Bank.
A pressure point was felt in 2004, when small and medium-sized Chinese mills were forced to turn to a nascent spot market to buy their ore -- mostly supplied by Indian miners. At that time, the spot market was small -- it grew to just 8%-10% of global turnover in 2007 -- but with all the controversy over benchmark prices in the past three years, it now accounts for almost 50% of transactions.
"So to some extent, the protracted issues over the last three years have helped proponents of the spot/index system because all iron ore participants now understand and utilise the spot market actively," pointed out Key.
Other factors have also influenced a change in the pricing system. These include: higher freight rates which put the Australian miners at a disadvantage compared to Vale (in Brazil) because prices are negotiated on an FOB (free-on-board) basis; the fact that pricing was becoming increasingly differentiated anyway; and the fact that negotiations for the annual benchmark price had became too protracted, often dragging into June without resolution.
Also, last year the spot price collapsed and many mills reneged on contracted deals and chose to buy their iron ore in the cheaper spot market instead -- which is ironic now that the spot price has moved to a 100% premium to the benchmark rate as a result of a return of demand for commodities this year.
Kamal Naqvi, global head of institutional commodity sales at Credit Suisse identifies two main tipping points, forcing a change to the iron pricing mechanism.
First, the major producers believed that buyers held the upside optionality through the benchmark system, as benchmark prices were often at the lower end of the spot price range. This concern was further inflamed when some steel mills reneged on benchmark contracts during the marked correction in spot prices in late 2008.
Second, some Chinese steel mills had been selling iron ore on the domestic spot market after having overbought at (lower) benchmark prices, earning significant profit margins.
The iron ore price is currently $160 per tonne (on a landed basis), which is up 100% from its lows early last year, but still below the $180-$185 high in May 2008. On an FOB basis, producers are being paid record highs.
Market participants generally reckon that among the top three producers, Vale supported retaining the benchmark system, BHP Billiton favoured a change, while Rio sat on the fence.
Naqvi believes that in the future "hybrid pricing is likely to characterise the market, with a mixture of long-term, quarterly and spot pricing approaches agreed between individual steel mills and producers".
In May 2008, Credit Suisse and Deutsche Bank set up a swap market for iron ore, which quickly saw trade volumes total about 200,000 tonnes a month. That monthly number will reach 3 million tonnes this year, which is equivalent to 36 million tonnes a year. Key expects volumes to reach 100 million tonnes in 2011 and continue to enjoy significant growth from there.
The size of the physical market for iron ore is around 1 billion tonnes a year. A rule of thumb is that derivatives markets range from three to 15 times the size of the physical underlying commodity, so potentially the market could grow to 15 billion tonnes per year. "We expect banks and trading houses to be the biggest players in the market, and perhaps, the template for the market is another bulk commodity -- coal," said Key. Meanwhile producers and consumers will use swaps to hedge, and to eliminate basis risk.
Credit Suisse has seen a marked increase in interest from Japanese and Korean steel mills, exploring ways in which they can use the swap market. Previously, the market has been largely confined to physical traders, banks, and financial players.
The swap market is likely to remain traded on an over-the-counter (OTC) basis, with exchanges functioning as clearing houses for some contracts. The Singapore Exchange (SGX) has already stolen a march on its rivals as the market leader, using the TSI index, although LCH (also using TSI) and ICE (using the rival Platts index) are keen to take more of the action. Physical pricing is likely to determine which index will gain the widest acceptance in the derivatives market, according to Key.
Corporates often prefer bilateral swap arrangements with a bank, which allow them to take advantage of allocated credit lines, instead of posting margin to an exchange, as this is a more efficient use of capital. Hedge funds and smaller trading groups currently have a preference for the clearing system.
So, "large transactions take place OTC, and are dominated by the producers, funds and banks. Smaller deals are usually cleared on exchanges -- notably Singapore (SGX) -- where a number of smaller physical traders are already trading freight," pointed out Naqvi.
Most of the trading on the SGX is short-term (typically one to two months), and agreed by physical traders. Larger corporate deals -- be they producer or consumer -- tend to be longer dated with up to three years currently available. "Price certainty is important for their spending plans and strategies," Naqvi added.
Both Credit Suisse and Deutsche, the pioneers of the iron ore swap market, agree that volumes are set to rise dramatically. They also agree that there is another commodity which must soon abandon its archaic pricing system: coking coal.
