Published on: May 04, 2010 at 21:30

The death of the annual benchmark contract system for annual iron ore is now a fact. Rio Tinto joined BHP Billiton and Vale in early April to commit itself to quarterly iron ore contracts, spurning the traditional annual benchmark mechanism.

This spells the death of the benchmark system used by iron ore miners and the global steel industry for decades. It will also spark a rapid rise of iron ore futures’ trading, in anticipation of a further shift to spot or index-linked pricing mechanisms. The new quarterly contracts, near $130/dmt (delivered basis) for Pilbara iron ore fines for the new Q2 2010 period, reflect average spot prices in the previous quarter.

This means, according to our estimates, and based on spot iron ore prices in early April 2010, the next quarterly contract could see prices rise to more than $150/t.

China obviously opposed. China’s steel producers are bitterly annoyed at this development and are desperately trying to cling onto the annual contract system, but the tide of history is against them. Their bargaining clout is weak – China’s crude steel production is running at a record annualised rate of 656 Mt, while its domestic iron ore sector is high cost and supplies poorer quality raw material.

The China Chamber of Commerce of Metals, Minerals and Chemicals Importers and Exporters (CCCMC) has now banned traders from importing iron ore of less than 60% iron content, and this will, paradoxically, play into the hands of Vale, Rio and BHP, as it will probably have the effect of reducing imports of lower grade Indian iron ore.

The CCCMC’s aim is to rejuvenate the domestic iron ore sector; but steel mills, which are exempt from the ban, may simply choose to import more ore from Australia and Brazil, so prices for higher-grade material will likely increase. We see the new quarterly contracts rising quite strongly throughout 2010.

US and European steel mills to feel impact in Q3/Q4. While restocking is taking place, EU and US steel producers should be able to pass on the higher costs of iron ore and other raw materials, but restocking will not last forever. We anticipate that in Q3 restocking will ebb and higher steel prices will be that much harder to swallow while real demand is still in the early stages of recovery.

Short-term outlook on steel

Prices in Q2 are rising. LME Med prices have gained 37% since late February to early April, hitting $620/t on 9 April. We expect prices will continue to rise to June but come under pressure thereafter, as restocking fades. Short term LME steel Med contract price: $650/t.

Key events on steel
Apr 10: US regulators have not lost their interest in curbing high frequency trading. The latest idea for managing the phenomenon comes in the form of a proposal that hedge funds use special identifiers when trading US equities via a broker. Currently such trades are only identified via the sponsored broker dealer, making it difficult to track executed trades to their original source. Regulators argue that this makes it difficult to monitor potential market abuse. A system of unique market participant identifiers could soon be in place under a “larger trader reporting system” being contemplated by the SEC.