Iron Ore Swaps: Volumes Rising, But Is There Enough Liquidity?

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MetalMiner guest commentator Pia Marie A. Trellevik is a senior iron ore derivatives broker in the London office of FIS Ltd., the London-based global commodity interdealer brokerage firm.

A lot of the posts we’ve written over the past few months have covered very new futures markets within the steel complex that we believe have tremendous potential, even though their actual volumes remain low. Today we would like to highlight the one market in the “virtual steel mill that has been the true success story of the past few years — iron ore swaps and options.

The Evolution

Everything changed in 2009 when the mills and mines threw out their yearly price negotiations for physical iron ore sales and switched to a quarterly pricing mechanism. This seminal moment in the iron ore trade ushered in a new era of volatility in the physical iron ore market. With this volatility, uncertainty increased as well, driving both traders and mills to look for an alternative way to lock in their input costs. This is what has driven the development in the iron ore derivatives market. Just as we saw in the oil market of the 80s and 90s, when the long-term pricing mechanisms ceased, the market called for a solution and found it in derivatives. Nowadays, oil futures trade at a high multiple of the underlying commodity and while we are not quite there yet on iron ore futures, this year can surely be considered a watershed for the market.

The New Reality

2009 marked the first year for iron ore futures trading, with April — the first trading month — seeing 190,000 tons go through. Fast forward just two short years to May 2011 when 3.5 million tons of iron ore futures traded. 2009 saw a total of 7 million tons trading; 2010 volumes ramped up to 20.5 million tons; 2011 is shaping up to far exceed that amount. For the year to date, we stand at 28 million tons traded and are on target to exceed 40 million for the calendar year.

The iron ore market was as reluctant to change as the current various steel markets. But the iron ore market quickly adapted to this new paradigm and has educated itself and started to utilize these derivative contracts to help protect profit, hedge input costs and lock in forward periods, creating synthetic long-term deals that before were locked in during the yearly contract negotiations.

The current market is made up of all segments of the industry: mines, mills, traders, financial institutions. This robust dynamic has led to a price discovery marketplace that has shed light on an otherwise very opaque trade. Spot and forward iron ore pricing now is transparent and liquid, giving all participants the knowledge to make informed decisions. This allows price discovery to best reflect the market view on supply and demand. Of course, while the futures market can become disjointed from the fundamentals as happens in all derivatives markets from time to time, in the aggregate the market is better off for having such a robust futures market.

The indexes on which the settlement prices are based have become ingrained in the physical trade with more and more deals being concluded “index linked. This paradigm shift has changed the shape and nature of the global movement of iron ore. The futures and options market have given users yet another option to exploit for profit or utilize as a safe haven.

The developments in the iron ore derivatives market should be viewed as yet another example of how the changing nature of global commodity trading continues to evolve; providing the most efficient market in terms of transparent price discovery further levels the playing field for all involved in the industry.

–Pia Marie A. Trellevik

Note: The views and opinions expressed in this post are held exclusively by FIS Ltd., and may not necessarily be shared by MetalMiner.

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