For 40 years the mining and steelmaking industry set the price of iron ore according to the following system: the first agreement each year between a global miner and steelmaker set a benchmark that the rest of the industry followed.
After several attempts to introduce changes since 2007, the system broke apart last year. Vale of Brazil, Rio Tinto and BHP Billiton, which account for the bulk of iron ore sales, agreed to a 33 per cent reduction with Japan, but China rejected the “benchmark” deal, arguing for a deeper price cut.
At the same time, BHP Billiton, which has been campaigning against the traditional system for two years, revealed that a third of its customers had undertaken to buy iron ore based on contracts linked to the nascent spot market. Last year, Vale and Rio Tinto sold large amounts of iron ore on the spot market.
The demise of the benchmark – still a work in progress that is likely to take years and could see the traditional system surviving in certain pockets such as Japan – is a big upheaval for the mining and steelmaking industry after 40 years of uniform dealmaking. It will also have an impact beyond the miners and their customers.
Steel represents almost 95 per cent of all metal used each year: Christopher LaFemina, mining analyst at Barclays Capital, says: “Iron ore may be more integral to the global economy than any other commodity, except perhaps oil.”
Iron ore prices filter down into steel costs and, ultimately, into the price of goods from cars to washing machines. As a result, the iron ore price is one of the key drivers of global inflation, analysts say.
The pricing change is not a surprise – iron ore is the only critical commodity whose price is still negotiated in such a way and the market is simply following other examples, such as the transformation in crude oil prices in the late 1970s, aluminium in the early 1980s and, more recently, dry bulk commodities such as coal in the early 2000s.
Alberto Calderón, chief commercial officer at BHP Billiton in London, says the evolution of the coal market could be a model for iron ore: “Even seven years ago, we were in a similar situation to iron ore. There were long negotiations – what I call very long lunches – benchmark negotiations, which used to create complexity and misalignment and so we pushed for a spot price,” he remembers.
Mr Calderón says customers do not regret the move to a spot market: “If you asked any of the customers if they would like to go back to the system of seven years ago more than 90 per cent would say no.”
Richard Elman, founder and chief executive of Noble Group, the Hong-Kong-based commodity trading house, says long-term contracts for most commodities no longer exist, but concedes the move to a new form of pricing will take time.
“It is a question of education. It’s the same as the coal business; it has taken a long time for people to understand that the swaps market in the coal business is a good thing,” he explains. “People have to overcome prejudice, and I think it is a generational thing as well.”
The progressive importance of the spot market has seen the emergence of derivatives – iron ore swaps – in which speculators, producers and consumers can bet on the direction of prices. The market was created by Deutsche Bank and Credit Suisse in 2008. Since then, other banks, including commodities heavy-weight Morgan Stanley, and brokers such as London Dry Bulk and Freight Investor Services, have joined.
Spot physical and swaps iron ore prices have been volatile this year amid divergent views on China and the global economy. After falling as low as $50 a tonne early in the year, prices rallied to $115 in September, before falling back to $85-$90.
Although the move away from the benchmark was expected, the speed of the change has surprised even those mining executives who had pushed for a break with the traditional system. The new system is evolving so quickly that the industry has yet to agree on the way forward.
Some steelmakers and trading houses in Japan and the China Iron and Steel Association, the industry body staffed with former government bureaucrats who led Beijing’s rejection of this year’s benchmark agreement, probably hope to preserve the benchmark system, which they think has worked well for 40 years.
Xu Zhongbo, of Beijing Metal Consulting, thinks some key actors in the iron ore industry favour the benchmark: “The big Chinese mills like the benchmark system and the Japanese like it. If the main steel producers in the world still like the benchmark, it will survive, at least for the next three years or so.”
In the words of an industry insider familiar with Beijing’s thinking, for Chinese authorities, the benchmark remains crucial. “They are unreconstructed central planners who can’t get used to the idea of not dictating prices,” he says.
There is a split among miners. BHP Billiton, the third largest ore producer, strongly favours pricing based on the spot market. The group has developed an index which averages spot quotations and forward swaps on a quarterly basis, and it is pushing customers to adopt it.
Some customers, including Bluescope Steel, the Australian steelmaker, have already moved into this new generation of contracts linked to the spot market and the miner has said that it will not renew old benchmark deals.
Rio Tinto, the world’s second largest producer, has in the past supported the benchmark system, but this year indicated that it was ready to move. Rio’s willingness to change reflects the main problem in the current system.
When prices are high on the spot market, steelmakers have stuck to the benchmark system, profiting from lower prices, but when spot prices plunge, some steel mills – particularly in China – have defaulted on the benchmark, instead buying on the spot market. In essence, the benchmark system has provided protection for the steelmakers, but not for the miners.
Tom Albanese, Rio Tinto’s chief executive, has indicated that he is aware of the problem and is ready to move.
Vale, meanwhile, still supports the benchmark system. It fears that any move to prices linked to the spot market could put it at a disadvantage because of the higher transportation costs from Brazil to Asia. The miner, however, has stated that it is ready to supply iron ore in whichever pricing system its clients choose, a softer approach than in the past.
After 40 years of a monopolistic approach to pricing, it seems that secretive meetings to settle annual prices may soon be over.‹
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