UPDATEEvents, and their major competitor, are conspiring to help...

UPDATE

Events, and their major competitor, are conspiring to help BHP Billiton and Rio Tinto in their quest to radically re-shape the pricing framework for iron ore and move it away from the annual confrontation with steel mills to a more market-related regime.

Under the benchmark pricing system contract prices are negotiated annually, with the first deal struck with the producer traditionally setting the "market" price.

The first crack in that system appeared this year, when Vale of Brazil reached an early agreement with the mills but Rio and BHP held out, with partial success, for some recognition of the freight differential – the lower cost of shipping ore from Australia to China and Japan relative to Brazil.

Then, about a week ago, Vale infuriated the mills by demanding that the mills pay 20 per cent more for its ore than had been agreed in the contract negotiations earlier this year, generating a large question mark over the value to the mills of the benchmark pricing regime.

The differential pricing won by BHP and Rio, and Vale’s decision to try to renegotiate its deal, have occurred against the backdrop of falling spot prices that have narrowed what had been a very significant gap between spot and benchmark prices. The combination of developments appears to be thawing the mills’ previously fierce opposition to the concept of index-related pricing.

Their opposition was, from their perspective, well-founded. The Japanese and Korean mills, and the larger Chinese mills, had been able to play the three big producers off against each other to obtain price advantages under the benchmark system relative to what would probably have achieved in a more market-oriented pricing environment. Until the freight differential was partially recognised, the system had also suited Vale, which effectively received premium prices for its ore.

The losers in the system were the smaller mills, who were forced into the spot market to obtain their supply, paying massive premia over the benchmark prices in the process.

This year, Vale became a loser. Its response has shaken the big mills’ conviction that the benchmark system favours them while the narrowing of the gulf between the benchmark and spot prices has demonstrated that a more market-oriented pricing regime may not be as threatening as they had previously supposed.

The concept of an index-related regime to establish the pricing, probably at monthly or quarterly intervals, for long-term contracts was first raised by BHP a couple of years ago.

Rio initially remained on the sidelines of the argument but more recently has argued for regular resetting of the price by reference to the spot market. It has also, much to the chagrin of the big mills, been diverting up to 15 million tonnes of its output – output that would in the past have been subject to benchmark pricing – to the spot market.

Shifting to more market-based pricing frameworks, where the index would provide the reference point against which differences in the quality of the ore could be priced by negotiation, is likely to be an evolutionary process, both because the benchmark approach has favoured the big mills in the past and because the mills are quite conservative.

The foundations for index-pricing are, however, in place. Earlier this year Credit Suisse and Deutsche Bank established an over-the-counter market to trade iron ore swaps. The swaps are settled against indices for spot iron ore prices devised by several industry publications.

Despite the immaturity of the market, there appears to be quite solid trading volumes, with some reports that swaps covering as much as 5 million tonnes of ore are being traded each month. The swaps are settled in cash but as the market develops it would be possible to provide the option of physical delivery to strengthen the credibility of the pricing.

There are apparently several more investment banks planning to enter the market and a number of commodity exchanges planning to offer derivative trading of iron ore.

The development of a deep financial market for iron ore would enable the mills and the producers to hedge their pricing and help generate a convergence between benchmark and spot prices that might better balance the interests of both the mills and the producers, as well as removing the inevitable combativeness and tension generated by the annual negotiations.

It would also reduce some of the concerns the mills have about BHP’s proposed merger with Rio and the prospective contraction of the number of major iron ore producers from three to two if prices were set by the market at arm’s-length to the producers.