Iron Ore is the world’s second largest commodity market by value (after crude oil). Iron ore is the key ingredient in steel making which accounts for 95 percent of the world’s metal consumption. China, Japan, Koria, United States and European Union are the leading consumers of the Iron Ore. Whereas the production of Iron Ore is concentrated in hands of three big miners, Vale, BHP Billiton and Rio Tinto Group. These three miners account for over 66% of the total iron ore market share.
Pricing Mechanism: Need for Structural Shift
Over the last four decades, Iron ore prices have been fixed between miners and steel makers as per Annual Pricing System also referred as Benchmark System. Under this system single price was negotiated once a year. In addition to this contractual agreements there was also a spot market available for any excessive demand or supply.
This Benchmark system offered the price stability to miners as well as steel producers and helped them in production planning. However, the system offered protection to steel mills but very little protection to miners. Since late 90s the market equation began to change, there was a shift from Buyer’s Market to Seller’s Market. Due to China’s huge steel needs iron ore prices began to soar and miners began to question annual pricing system.
In March 2010 three major miners, Vale, BHP Billiton and Rio Tinto and steel makers agreed to change the Iron ore Pricing mechanism (from Annual Fixed price contract to spot pricing). Currently instead of annual fixing quarterly benchmark price is decided between miners and still manufacturers.
New Paradigm and its Impact
Global steel industry was leveraged with the excess capacity and was expecting a revival in global steel demand. As a result, post 2009 spot market price of iron ore were always used to be higher than annual benchmark. Therefore the iron ore prices firmed up significantly after the break down of benchmark pricing system in March 2010. Market witnessed over 100% of rise in iron ore prices in April-June 20 10 quarter over 2009-10 annual benchmark price of USD 60 per tonne.
Impact on Steel Industry: Like many products in steel industry also price discovery is the function of demand and supply/ installed capacity. Therefore it is not always possible to pass-through the raw material price hike to the end users. In addition to this steel industry plays a vital role in overall industrial and infrastructure development. Therefore Indian government has taken significant steps to support Indian steel makers that are facing shortage of ore supplies and thereby firm RM prices. India is the third largest supplier of iron ore to china (after Australia and Brazil). Government has raised the export duty on iron ore lumps to 15 % in April 2010 from 10% previously. This action was taken to restrict the iron ore export to china and to ensure domestic procurement for Indian steel makers. Further hike in iron ore export duty (up to 20%) is also expected in near future.
Impact on Commodity Devivative Market: Over recent years the Spot market had developed in terms of size and its importance. As a result Iron Ore Swaps have emerged (in 2008) as financial hedging instrument to cover iron ore price risk. Historically we experienced exponential growth in commodity market after it’s pricing is decontrolled e.g. crude derivatives in late 1970s, Aluminum derivatives after early 1980 s and recently in thermal coal derivatives. Similarly with the shift in pricing mechanism, the market analysts forecast that the iron ore swaps market will grow to $200bn by 2020 from $300m today.
Way Ahead
As a result of this change, steel manufacturers and miners would prepare themselves to tolerate commodity price risk. Iron Ore derivative market will grow in size and we will witness development in financial market to hedge this commodity risk. There would be increased correlation between domestic and international iron ore prices. In course of time even steel users would face a cascading impact of iron ore price volatility.
This is a sign of a developed market, as the price becomes the function of demand and supply. However, this may result in speculative transactions in financial derivative market. Considering the wide spread and cascading impact of Iron Ore price fluctuations, regulators and players would try to restrict speculative transactions. However, needless to say that trader would find the loopholes …
Its more likely than not that Japan will come out of this natural calamity without lasting damage to its own economy. But how long the process will take is anybody’s guess.
( Source: www.steelguru.com )