Iron Ore Annual Benchmark Price Negotiation Model Has Had its Day

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Has the traditional annual negotiation model used by Vale, BHP and Rio on the supply side and Bao Steel and the China Iron & Steel Association on the other to set benchmark iron ore prices come to the end of its useful life? The answer is yes it probably has. The annual rounds of negotiations which start in late November/early December and set out to fix a price by April 1 for the following year’s sales has never been easy but the last two years have become increasingly acrimonious due in large part to the extreme volatility in the iron ore spot market creating almost irreconcilable positions for both buyers and sellers. The 850m ton iron market was worth about $160bn at 2008’s record prices but the percentage traded on the spot market has grown rapidly from about 90m tons to 180m tons according to the FT newspaper reporting on comments by BHP.

As the spot market has grown, so has the over the counter (OTC) derivatives market led by Singapore last month. Prior to the development of an OTC clearing market, buyers and sellers took the full risk of default from their counter party on their own books. The development of a cash settlement clearing mechanism has opened up the market for many more users to take advantage of the opportunity to fix prices and settle financially without having to take or make delivery. In the one month since opening, volumes have rapidly increased and with them liquidity  that has seen buy/sell spreads fall to $1 from $3-4  according to the FT. Hot on the heal of Singapore, the European clearing house LCH Clearnet has now introduced a clearing market for OTC iron ore contracts and several merchant banks are in different stages of offering a market lead by Morgan Stanley, Goldman Sachs and Barclays following a lead set by Deutsche Bank and Credit Suisse.

The reality is as these and others develop a vibrant OTC market, traders, buyers and increasingly sellers will be encouraged to move ever larger portions of their volume through the markets or use the prevailing prices as the benchmark for their transactions making the annual price negotiations redundant.

Will this lead to greater stability in iron ore prices?

Supporters would have us believe it will. In reality, as with base metals there is always a speculative element active in such markets and the answer is no it probably won’t add to stability but it will allow a fairer market price to prevail, one reflecting the true state of supply and demand rather than what we have seen over the last few years which has been a case of just 2 or 3 major producers holding the principal consumers (and by default the rest of the market which follows) to ransom. We suspect this will be the last year in which annual negotiations are seen as the de facto world price for iron ore. By 2010 and beyond a more flexible pricing environment will have become established.

–Stuart Burns

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