new era for iron ore negotiations?

An interesting artile from the financial times.

Annual iron ore ritual in doubt
Published: April 16 2009 17:49 | Last updated: April 16 2009 17:49

At a recent mining conference in Perth, the capital of the iron ore industry in Australia, delegates were asked to put their hands up if they thought the current system of annual iron ore negotiations would still exist in five years’ time. Very few hands were raised.

The current system, known as the “benchmark”, has been the cornerstone of the iron ore market since the 1960s. Miners Rio Tinto, BHP Billiton and Vale of Brazil sit down every year with Chinese steel mills in secretive negotiations to thrash out prices for contracts for the year beginning April 1. In former years the lead role was played by the Japanese mills.

“Within the next five years we will see a shift away from the current benchmark system,” says Jim Lennon, a commodities analyst at Macquarie bank in London, echoing a view that is quickly gaining support within the industry.

The annual price negotiations have a great influence in the global economy as the cost of iron ore filters down into steel prices and ultimately into goods such as cars and washing machines. A move away from the annual benchmark prices to spot or hybrid contracts could lead to more volatile prices for steel and other goods.

The annual negotiations have become more acrimonious and no settlement has yet been reached for the year beginning at the start of this month. Miners and steelmakers are still negotiating 2009-2010 contracts, which are likely to deliver the first drop in prices after six consecutive years of increases.

The move is unlikely to be sudden or lead to the complete disappearance of the benchmark in the short term. Rather, executives envisage a gradual move, with spot sales, hybrid contracts and some legacy benchmark contracts co-existing.

“It will be a mix,” says a senior executive, who remains convinced that the benchmark system has its benefits as it provides investment certainty

Paradoxically, the actions of the two more ardent defenders of the benchmark system, the China Steel and Iron Association and Vale of Brazil, are sending the strongest signals to suggest its days are numbered.

On the one hand, the CSIA is asking miners to cut their prices to 2005 levels, below current spot rates. Miners have warned Beijing that if the CSIA continues to make such a request, they are ready to let their benchmark contracts expire – something that will start to happen in mid-June. At that point, they will shift all their tonnage into the spot market.

On the other hand, Vale is selling more and more ore into the spot market, a U-turn for the Brazilian company, which has previously criticised any move away from the benchmark.

The most important development is the growing liquidity in the spot market, says Mr Lennon of Macquarie. “There is a growing acceptance to use the spot market as a reference,” he says.

Alan Heap, a mining analyst with Citigroup in Sydney, estimates that last year almost 40 per cent of global seaborne trade of iron ore, plus domestic sales in China, was priced against the spot market, up from just 15 per cent in 2001. Traders say spot sales have risen even more this year, with all the big miners – particularly Vale – increasing their spot deliveries into China, mopping up unwanted tonnage under the traditional benchmark system from customers in Europe and elsewhere.

Raymond Key, global head of metals trading at Deutsche Bank, says that the infrastructure to trade round the spot market is increasing and the industry is getting more comfortable. “It is like learning to ride a bicycle, once you have done it a few times, you get used to it and there is no coming back,” he says.

Although there are large differences between the iron ore and oil industries, some executives see a parallel with the development of the spot crude oil market in the late 1970s and early 1980s. This saw the oil industry moving away from long-term contracts with fixed prices to spot prices. Today, no one in the oil industry suggests a return to the days of endless negotiations between the producing countries and the refiners to agree a fixed price.

The move away from the benchmark system will benefit banks such as Deutsche Bank and Credit Suisse, which a year ago launched an off-exchange market platform to trade iron ore swaps that is slowly gaining traction. Bankers believe other players may soon launch similar products, building round their current business of coal and freight derivatives.

Ciao HB