Brave New Ore: The End Of Benchmark Pricing

April 06, 2010

With the iron ore benchmark system officially declared dead, what will become of steel prices?
  • How the benchmark system collapsed
  • The new world of pricing
  • Will steel-makers falter?


Each year, the big three iron ore companies Vale (NYSE: VALE), BHP Billiton (NYSE: BHP) and Rio Tinto (NYSE: RTP) go through a complex dance with the major steel manufacturers in Asia, attempting to set the best benchmark price they can for iron ore shipped by sea. Negotiations begin well before the contract date of April 1, with miners attempting to get the highest prices they can, while steel-makers try to keep prices as low as possible. Eventually, one of the ore companies and a large steel-maker in either Japan or China arrive upon a price that neither is completely happy with, and that price serves as the benchmark for other negotiations.

This is how things have gone for the past 40 years. Until now.

This year, tentative deals announced around March 21 signaled the end of traditional benchmark pricing on yearlong contracts. The Financial Times quoted a senior executive involved in the negotiations in Japan as saying, "There is an understanding on both sides to move to quarterly pricing. The negotiation is no longer about annual contracts."

By March 30, the benchmark pricing system was officially declared dead, and the market turned its attention to figuring out who would profit in this brave new world.


The New System

Before we determine who might gain from this change, we should first look at exactly what the change is.

The new system consists of shorter, quarterly contracts that are linked to an average of the spot market. (Currently, the spot market is estimated to handle approximately 10 percent of all iron ore transactions.) With quarterly contracts, iron ore prices will track spot prices more closely, rather than being disconnected from the commodity's ever-changing supply and demand picture.

The Financial Times notes that each steel-maker will use its own formula to calculate the new prices. For example, the paper noted that ore priced to go to Japanese steel-makers next quarter has been calculated from the average spot price from December to February - approximately $108/ton, minus freight costs. On the other hand, Chinese steel-makers are looking at prices closer to $119/ton, because they're using the average price from the first quarter of 2010 as their reference.

It's a small difference, to be sure, but it suggests that in future contracts, huge price swings could occur in one country's contracts but not others, simply due to timing.


The Fallout

So what does this change mean? In a nutshell: No one is sure yet. But many analysts are predicting huge windfalls for miners, as their contract prices could swell 80-100 percent from last year's lackluster prices. Vale, for example, was stuck last year with an annual contract price of about $55/ton for the contract year ending on March 31, while the cash price for similar Brazilian ore reached $138.50/ton on Feb. 26, an 18-month high.

In the other major iron-ore-producing region, Australia, the benchmark iron ore hit a price of $153.6 a ton at the end of March. Not too shabby.

BHP, Vale and Rio Tinto have been already seeing improvements in their stock prices, as the end of benchmark pricing drew nearer:


Iron Ore Stocks



BHP is up 8 percent year-to-date, while Vale and Rio Tinto are up 13 percent and 14 percent, respectively. Of course, how much of this is due to a positive sentiment in the market toward the new pricing system versus the current economic recovery is hard to tease out. But some of the big steel manufacturers aren't seeing the same type of increase as the miners are seeing:


Steel Makers


ArcelorMittal (NYSE: MT), the largest steel manufacturer in the world, is only up about 1 percent since the beginning of the year. And Japan's largest steel company, Nippon Steel, is down almost 1 percent.

Steel-makers around the world warn that increased iron ore prices will be passed along the value chain, resulting in higher prices for consumers; in fact, some are calling for regulators to investigate the big three ore companies' market behavior. But realistically, not all of the costs can or will flow through to consumers, as there's too much risk involved in slowing the economic recovery or the nascent increases in demand. B. Muthuraman, vice chairman of Tata Steel Ltd., is quoted by the Wall Street Journal with regard to passing on costs, and he's not optimistic, stating, "Twenty-five percent could be passed on, but nothing more than that."

Of course, high spot prices may not be here to stay. Pedro Galdi, a mining analyst with SLW Corretora in Sao Paulo, told, "The spot market price is determined by Chinese demand. If China stops buying, the spot price will fall and miners will have to accept lower prices. What about next year? Everybody is investing to increase capacity, so later on supply could overtake demand."

What China does, of course, has huge ripple effects on the entire industry, as the country is the recipient of approximately 70 percent of seaborne iron ore shipments (which hit 900 million tons last year). And it looks like it will try to use some of that clout: The China Iron and Steel Association has reportedly called for Chinese steel companies to boycott Vale, Rio Tinto and BHP Billiton and stop buying ore from the companies in the next two months.

Domestic steel companies have built up their stockpiles in the past few months, so theoretically a boycott wouldn't slow steel production. Eventually, however, China would need to resume importing steel. The question now is, will the steel-makers comply? Or is this just posturing? We'll just have to wait and see.

For the moment, you can track steel prices with the Market Vectors Steel ETF (NYSE Arca: SLX), which tracks the largest, most liquid companies engaged in steel manufacturing. Year-to-date, SLX is up 16.56 percent.


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