Iron Ore Swaps Market to the Rescue

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For steel consumers the change to quarterly iron pricing in Asia and the resulting fait accompli that Europe would be forced to follow must have been viewed with dread. For 40 years the benchmark system of contract iron ore prices has allowed steelmakers to fix prices for steel semis up to one year forward. This allowed steel consumers to price their products from cars to washing machines with some degree of confidence that the major raw material cost inputs wouldn’t change.

Well that’s all a thing of the past now, due to Chinese demand pushing spot prices to dramatic premiums over contract prices. Iron ore miners have felt compelled to shift contract pricing to a more flexible formula that more closely follows the spot price. Enter the quarterly contract amid anger from steelmakers who see not only their costs rocketing but risk multiplying dramatically. ArcelorMittal, the world’s largest steelmaker, said in a Bloomberg Businessweek article it will raise its steel prices in Europe as much as 16% after an “overwhelming surge in the cost of iron ore and coking coal.

ArcelorMittal will increase benchmark European hot-rolled coil prices to 650 euros ($825) a metric ton in July, from 560 to 620 euros currently.

The steelmaker says it has no alternative other than to pass on cost increases to its clients, but we ask whether that is true. All steel makers that rely on iron ore as an input and who are not vertically integrated with their own mines are facing the same problem. ThyssenKrupp for example Germany’s largest steelmaker, is according to a different Businessweek article, among those considering using new Iron Ore Swaps to hedge against more rapid price swings. The swaps allow buyers and sellers to fix prices for single cargoes of the material months in advance and were launched by Credit Suisse and Deutsche Bank in May 2008. The end of the annual contract and introduction of the quarterly price model could not have come at a better time for the young derivatives market. Volumes have grown dramatically this year. Some 100 participants are now involved in the market and trade grew to about 5 million metric tons in April, from 2.8 million tons in March. Swaps trading cleared on exchanges totaled 2.5 million tons in April, with over-the-counter trades carried out off exchanges about the same according to Phillip Killicoat, market specialist at Credit Suisse quoted in the article.

So steel makers and even major steel consumers have the ability to hedge their price risks via iron ore swaps. The qualification requirements for opening a swaps account are not a barrier for significant players in the market such as steel mills or major consumers such as automotive companies or major white goods manufacturers. The biggest hurdle is education and corporate acceptance in using hedging derivatives. For some steel companies and consumers the biggest barrier to achieving a degree of control over price stability may be their own treasury department.

–Stuart Burns

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