The signing was announced last week of the first ever Japanese iron ore swap. This contract, between Mitsui and Credit Suisse, is designed to protect Mitsui against movements in the price of iron ore up until the end of 2010.
Iron ore markets have experienced increased price volatility during the past couple of years. This has been due partly to turbulence in global markets generally but also, due to a fundamental change that has recently taken place in the pricing practices for physical iron ore supply contracts. The abandonment of annual fixed price contracts between the major mining companies and steelmakers in favour of quarterly contracts priced off the iron ore spot market potentially exposes both sellers and buyers to greater price fluctuations. This change has brought market practice in the iron ore market back into step with that in other commodity markets and appears likely to trigger significant growth in the relatively underdeveloped iron ore swaps market, both in the Asia Pacific region and beyond.
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The annual iron ore contract system
For the last four decades the use of annual fixed price contracts in the physical iron ore market has provided considerable price stability for market players. Prices have still fluctuated over the medium to long term, in response to supply and demand factors, but the fixing of prices across a one-year horizon has gone some way towards providing the necessary degree of commercial certainty that businesses in this sector have previously required in order to make strategic decisions on investment, borrowing, and acquisitions. The system worked by means of an annual price negotiation process between the major miners and steelmakers. By market convention, the first price to be agreed between one of the miners and one of steelmakers would be adopted by the rest of the market as a benchmark for all subsequent contracts entered into during the rest of the year. This system had the advantage not only of stabilizing prices but also of avoiding the time and expense of negotiating the price terms of each contract individually.
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End of the annual contract system
Cracks in this system became apparent when the annual round of price negotiations began in late 2008. By this time, the onset of the global financial crisis had caused demand for steel in China to plunge. It was clear to both sides that this would translate into a significant fall in the annual price for iron ore in the coming year. However, the question was how large this price reduction should be. China’s influence in the annual negotiations had grown considerably due the increase in its share of purchases in the global iron ore market, as its demand for iron ore began to significantly outstrip its domestic supply.
In 2000 China had accounted for less than 20 per cent of global iron ore purchases but by 2009 its share had grown to around 70 per cent of a market that had nearly doubled in size over the same period. By June 2009, well after the usual 1 April deadline for agreement to be reached, the “big three” miners, BHP Billiton, Rio Tinto and Vale, agreed a reduction of 33 per cent on the previous year’s benchmark price with Asian steelmakers outside China. However, the China Iron and Steel Association (CISA), insisted on a 45 per cent reduction, leading to a deadlock in negotiations. By the time that negotiations began in late 2009 for the annual 2010 contract price, rises in iron ore spot prices in the interim meant that agreement with CISA appeared even more elusive. Finally miners and steelmakers recognised that consensus was now impossible and on 30 March 2010 it was announced that the annual fixed price system would be abandoned from 2010/2011 onwards in favour of shorter-term contracts based on spot prices.
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The new system
The new system is market-based. Instead of using a fixed annual pricing benchmark, parties now benchmark against the average price in the iron ore spot market over an agreed period. This has led to wider variation in the contract terms agreed between parties, since, although quarterly contracts are now generally used, two different steelmakers may agree to different averaging periods for otherwise identical contracts covering the same quarterly period.
Market reaction to the new system has generally been positive, with some seeing it as representing the “normalisation” of the iron ore market relative to other commodity sectors. The pricing of physical crude oil has been based on the spot market price since the late 1970s, with aluminium following suit in the 1980s and thermal coal in the 2000s. One major consequence, of this “normalisation” is that the iron ore market is now subject to levels of price volatility much more in line with these other “normal” commodity markets than had been the case under the annual contract system. Up until the recent peak in spot prices in mid-April, this volatility had worked to the benefit of miners, who were able to enter quarterly contracts on the basis of much higher prices (typically between about 80 - 100 per cent higher than the fixed price agreed for 2009/2010 contracts), but since then prices have dropped again by about 25 per cent, providing partial relief to steelmakers. But in either case, players in the physical market have had to adapt to a business environment in which price risk has become a far more obvious factor than previously. We expect to see an increasing demand in the iron ore market for similar risk management tools to those already used in “normal markets”, namely derivatives.
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Iron ore derivatives
The persistence of the annual contract system in the iron ore market, long after its abandonment in other commodity markets, retarded the growth of the market for iron ore derivatives by depriving of it of the stimulus that led to the rapid growth of, for example, oil futures and swaps. After oil, the iron ore market is the world’s second largest commodity market by value and by a very large margin the most important base metal, representing 95 per cent of total annual volumes. On that basis, the current value of the iron ore swaps market, around US$300 million, is astonishingly low. However various developments are already underway that should address this anomaly.
- Cash-settled iron ore swap contracts, first developed in May 2008 by Deutsche Bank and Credit Suisse, are beginning to be adopted by physical players (miners and steelmakers), not only in Europe but now, with the Mitsui deal, also in the Asia Pacific region.
- The trading infrastructure necessary for the iron ore swaps market to grow is now taking shape, with numerous banks and other financial institutions building up trading capability in anticipation of growth in this sector and clearing houses such as Singapore’s SGX AsiaClear, CME Group, LCH. Clearnet and the IntercontinentalExchange already offering clearing of certain iron ore swap contracts.
- Gradual initial growth is likely to accelerate both as participants become more comfortable in terms of the liquidity and price transparency of the market and as, alongside physical players looking to hedge their price exposure, players such as banks, hedge funds, trading houses and, indirectly, retail investors enter the market for speculative purposes, attracted by high volatility and low barriers to entry relative to the physical market.
- As a result of this virtuous circle of growth, analysts predict that volumes in the iron ore swaps market will increase by several orders of magnitude to reach US$200 billion by 2020.
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The development of a “mature” iron ore swaps market will contribute to a more highly evolved physical market. Transacting in any commodity, whether as producer, consumer or trader, will involve various risks, among which price risk may be the most significant. The end of the annual contract system did not itself create price risk but simply ended the use of an obsolete risk management tool, namely annual price fixing. In the process it created the opportunity for the emergence of a far more precise tool.
Financial derivatives such as swaps are specifically designed to package and trade risk in their underlying asset class by creating cashflows that can be precisely matched to a particular set of business risks. On that basis they represent an advance over less developed price fixing mechanisms.
Price management in the iron ore markets will require stakeholders to understand the risks in using derivatives: who will be the first to find themselves in the same position as China Aviation Oil and its US$550 million oil derivative loss in 2004? If the risks are understood then the overall benefits from the growth of a specialised iron ore swaps market should more than compensate for the disappearance of a pricing system that no longer appeared to be fit for purpose.
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