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Iron-ore derivatives: Fixed ore floating

via The Economist: Finance and economics on 7/1/10

Iron-ore derivatives

Fixed ore floating

Steelmakers hold the key to a fast-growing market

Jul 1st 2010

FOR decades the system for setting the price of the iron ore that feeds the world's steel mills was as inflexible as the girders it was turned into. Annual negotiations between the world's three biggest miners—Rio Tinto, BHP Billiton and Vale—and steelmakers set a benchmark price for ore delivered under long-term contracts. But the emergence of China as a big buyer, which felt it should have more control over prices, helped precipitate that system's demise earlier this year.

That was a blow to steelmakers accustomed to predictable prices for their most important ingredient. Others are happier, however. Miners now sell their wares on the spot market or on three-month contracts linked to spot prices, avoiding fractious negotiations and enabling them to take speedier advantage of fast-rising prices. And the shift has also been a boon to traders in the rapidly growing market for iron-ore derivatives.

Many mills still supply their steel on long-term contracts. They are increasingly worried about awkward swings in the price of their main input. A couple of months ago, for instance, spot prices went over $190 a tonne; they have now settled at around $140. A 15% rise in quarterly contract prices is expected in July. In an effort to offer Japanese steelmakers a way to protect themselves from such volatility, Mitsui, a trading house that acts as a middleman between miners and steel mills, said on June 28th it had inked the country's first iron-ore swap deal with Credit Suisse.

Along with Deutsche Bank, the Swiss bank was a pioneer of iron-ore derivatives, launching the commodity's first over-the-counter cash-settled swaps in May 2008 in the expectation that the benchmark would go. Derivatives trading could account for 60m tonnes of ore, some 7% of the internationally traded market, by the end of 2010. Credit Suisse reckons that if iron ore follows the same path as coal, which was unshackled from a benchmark system some years ago, then swap volumes could hit 700m tonnes a year by 2013.

Others also sniff bumper profits. Morgan Stanley is now offering swaps. Brokers such as ICAP and Freight Investor Services are piling in, too. On July 11th Chicago-based CME, the world's biggest derivatives exchange, will join LCH.Clearnet in London, Singapore Exchange and New York's IntercontinentalExchange in offering cleared iron-ore swaps.

But for the market to take off in earnest steelmakers, a conservative bunch, need to be convinced of their usefulness. When iron-ore derivatives were first launched business came from investors such as pension funds and hedge funds who were looking for exposure to commodities that were not traded on exchanges. Big trading houses also use derivatives to manage risk in a business where margins are slender. ThyssenKrupp, one of Europe's biggest steelmakers, said in April that it was considering using derivatives. Japanese and Chinese mills may soon take the plunge. A recent threat by Rio Tinto that it could give up quarterly pricing and leave steelmakers at the mercy of the spot market may persuade them to lose their inhibitions.

Finance and Economics