Iron ore: will benchmark pricing go?

With the growth of spot pricing for iron ore, it looks as if the existing system, based on a benchmark price set by annual negotiations between miners and steelmakers, is coming under increasing pressure. Will benchmark pricing give way entirely to spot pricing? The largest iron-ore miners are adopting different stances to deal with changes in the way prices are set.

Iron ore production was 1.6 billion tonnes in 2007, with the three largest iron ore miners, Vale (VALE-N), Rio Tinto (RTP-N) and BHP Billiton (BHP-N), together controlling 35% of the market.

The concentration in seaborne iron ore is even higher: Vale alone controls 36% of the world market, and the three companies together command a 69% market share. Clearly, the pricing mechanism set by the big three iron ore miners exerts considerable influence on the entire industry.

Ian Ashby, president of BHP Billiton Iron Ore, who took part in Macquarie Securities’ Australia 2009 conference in early May, delivered a presentation which dealt with iron ore pricing, among other issues.

“What started out as an evolution is now almost a revolution to a more transparent system,” Ashby said. This occurred because, while China’s iron ore consumption has been growing, its domestic iron production has also increased, to the point where the country is now able to supply almost half its own demand. Most iron ore mined in China is traded on the spot market, so it is no wonder that this market has grown in importance.

“The rapid growth in China’s iron ore demand has created a two-tier market: one that is based on the traditional annual benchmark pricing, and another which is based on spot pricing,” Ashby said. “The growing spot market, together with the lengthy annual negotiations which have produced recent ambiguous outcomes, had started to break down the traditional benchmark system.”

Ashby believes that the significant growth of the seaborne spot market indicates that the benchmark system does not necessarily provide a more stable environment to consumers or producers. The iron ore spot price is highly correlated with steel prices, which are repriced daily, so spot pricing is a more suitable mechanism for steelmakers

“As a consequence, we are seeing more and more participants entering the spot market with a broader range or products,” Ashby says, and he draws a profound conclusion:

“. . . it should be clear to everyone that the changed market dynamics created by China’s voracious appetite for iron ore over the last five years or so, makes obsolete a system whereby pricing is locked in for 12 months, based on little or no market transparency.”

Ashby believes that, beyond the spot market, more transparent pricing will become available through the development of an iron ore index. He identifies three independent reference price providers: Platts, Metal Bulletin and Steel Business Briefing.

At present, the price indices only reflect the physical market, but a paper market has also started to develop, with two banks, Credit Suisse and Deutsche Bank, providing forward price curves. And in April, the Singapore stock exchange launched the first over-the-counter clearing mechanism for iron-ore swaps.

So the iron-ore industry is in the process of moving from a fixed-price, benchmark mechanism, to a fully developed commodity market. Far from being a mere onlooker, Ashby lends his wholehearted support to this fundamental shift.

“BHP Billiton is a proactive market participant. The company supports all initiatives that move the market toward being able to define the transparent landed price for our iron ore,” Ashby says.

Clearly the aspect that BHP likes the most about this state of affairs is the transparency in the pricing mechanism, while the company retains the ability to manage risk. BHP has been selling on the spot market, as well as moving to long-term, index-based contracts.

“We want to sell on long-term contracts and maintain long-term relationships with our customers, with the price settled against the index,” Ashby says. “I would expect that, just like any other businesses within the group, long-term contracts will remain the lion’s share of the business, but with reference to a market-clearing price.”

Fellow miner Vale seems to prefer the benchmark pricing system, but the significance of the shift to spot prices is not lost on the Brazil-based giant. In a news conference in early May to present the company’s results for the first quarter, Fabio Barbosa, Vale’s CFO, said that the company has adopted a more flexible commercial position.

“The most appropriate system for our industry is the benchmarking system,” Barbosa said. “However market circumstances, in fact, show that this is not the only possible system to be applied. There are other alternatives emerging. And what we have been saying is that we are ready to explore all alternatives available if this is the wish of our clients. From now on, the price levels . . . will really depend on our direct discussions with the clients.”

A spokesman for Rio Tinto declined to comment on iron ore price negotiations while they are still continuing. But in e-mailed comments to The Northern Miner, the spokesman raised a number of points. With respect to benchmark pricing, the spokesman wrote:

“Rio Tinto will continue to support the benchmark system so long as it reflects underlying supply and demand for our products. Some customers have suggested a benchmark price for this year below current spot levels which is not acceptable to us, particularly against an improving market outlook over the course of the year.”

Addressing spot market pricing, the spokesman commented: “The growth of the spot market has essentially been a Chinese market phenomenon. Its continued development will largely depend on whether the Chinese steel mills wish to adhere to long-term contracts with annual pricing or switch to a system of shorter-term purchases. As a low-cost producer, we can live with either system, or a combination of both.”

Commenting on the use of iron price indices, the spokesman wrote: “Price indices can play a useful role in indicating where the market is clearing. Iron ore indices are still in an embryonic stage and we are following their development with interest.”