The Benchmark is Dead, Welcome the Swap

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Some commentators are presenting the decision this week of a deal by Vale of Brazil and Anglo-Australian BHP Billiton with Japanese and Chinese mills as being momentous for the iron ore industry. It will in hindsight be seen as the end of the 40-year-old benchmark system of annual contracts but in reality it is just one step along a road started two or more years ago as cracks in the previous system became increasingly obvious. The process was seen early on by far-sighted investment banks such as Credit Suisse who developed OTC iron ore contracts back in 2008 knowing the increasing use of spot contracts would lead to the need for futures hedging facilities in the iron ore market. Mills have fought a valiant rear guard action but China’s refusal to accept last year’s benchmark deal was without doubt the beginning of the end. Leading Japanese steel mills, including Nippon Steel, and Chinese steelmakers, including Baosteel, have now signed the new quarterly contracts, executives said in an FT article. The first quarter of which will be at prices 90% over last year’s benchmark at between US$100 and 110 per ton but still below the latest spot price, now over US$150 per ton before freight.

European steelmakers have yet to sign any new quarterly contracts but traditionally the European producers settle after the key Japanese, Korean and Chinese mills have reached a deal. Europe is opposing the iron ore producers efforts on two fronts. First, via Eurofer the producers association, they are lobbying for the EU to investigate the big three’s monopolistic position in imposing quarterly price fixes. Second, they are objecting strongly to the size of the price rise warning finished steel prices will rise by a third as a direct result.

Meanwhile the investment banks are scrabbling to catch up with Credit Suisse and Deutsche Bank in bringing out derivatives products to cater to what will undoubtedly be an explosion of hedging activity. Both sides of the supply and consumption market will need to wake up to and embrace hedging opportunities if they are to manage the new normal of spot and quarterly pricing.  Steel producers have been used to selling and consumers have been used to buying on annual fixed prices for certain industries like automotive and for major projects like pipelines and refineries where deliveries run over a year or more. Steel mills will not be able to fix their costs for these periods anymore and will have to use swaps to hedge their risk or face the prospect of potentially selling metal at a loss if prices rise during the contract. For consumers who can’t get mills to guarantee fixed prices for extended periods, swaps may be the only way they can hedge against price increases driven by the raw material inputs of their suppliers.

Other banks have already joined in offering OTC products, including Morgan Stanley, the commodities heavyweight, and brokers such as London Dry Bulk, Freight Investor Services and Icap. According to an FT article other banks such as Barclays Capital, Citigroup, Goldman Sachs and JPMorgan are expected to become increasingly involved in the ore swaps market. Not surprisingly, analysts forecast that the iron ore swaps market will grow to $200bn by 2020 from $5bn today, and in so doing could provide a solution to the new volatility that both steel producers and consumers will face.

So the benchmark may be dead but the swaps market has come of age. The king is dead, long live the king.

If you are interested in attending our Q2 Steel Market Update, register here.

–Stuart Burns

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