Are Steel Mills Shortsighted in Iron Ore Contract Negotiations?

We’d like to put the subject of iron ore negotiations to bed (especially since they should have settled by now). But the major Chinese steel mills and the Big 3 iron ore mining companies (BHP, Rio Tinto and Vale) don’t seem to agree too much on anything. The iron ore contract negotiation process looks an awful lot like many of the contracts/arrangements we see industrial manufacturers make with their suppliers every day.

It works this way ” a buying organization buys say, aluminum, steel and stainless steel (in whatever form). Typically, that organization goes out to bid monthly for known orders (or demand) and selects the supplier with the best prices for the month. Best prices defined as lowest cost looking at both metal and fab costs. Other buying methods exist too. Perhaps the decision gets made on a quarterly or semi-annual basis. So far so good, but then something happens. Prices start to increase. Immediately buyers start calling on their suppliers to lock in costs if not for the monthly requirement, then the quarter or even the next six months to a year. If the buyer has a chosen strategic supplier, they will just execute a similar version of this strategy when prices start to rise.

Suppliers may (or may not have) actually locked in the pricing as agreed/discussed with the buying organization. Now let’s say a buying organization locks but prices decline (like they did last fall). The buying organization places a call to the supplier and says, can you fax me the paperwork showing me you have placed an order for my aluminum? If the supplier can show the paperwork, the buying organization agrees to honor the purchase price. If no paperwork exists, a process of we call weaseling ensues in which the buying organization seeks to renege on any verbal commitment (or even a blanket P.O.).

The weaseling works the other way too. How many times have we heard that suppliers quickly pass on price increases but fail to implement price decreases quickly? The iron ore contract negotiations resemble these same industrial manufacturer/supplier negotiations.

Historically, iron ore contracts settle in April using a traditional benchmark system. This system essentially protects steel mills from prices rising sharply through the year but also locks them into higher costs when the spot ore market falls, as it did in late 2008, according to this story from Reuters. But now, some want to move to spot market buying only, namely the Chinese steel producers.

Call me crazy but why don’t the steel mills purchase some of their requirement on a yearly contracted basis and float the rest on the spot market? Or better yet, use the new Singapore Exchange iron ore swap? It has to beat this game of weaseling.

–Lisa Reisman