HardAssetsInvestor

Written by Julian Murdoch  |

April 06, 2010

Brave New Ore: The End Of Benchmark Pricing

Details

With the iron ore benchmark system officially declared dead, what will become of steel prices?

• How the benchmark system collapsed
• The new world of pricing
• Will steel-makers falter?

 

Each year, the big three iron ore companies Vale (NYSE: VALE), BHP Billiton (NYSE: BHP) and Rio Tinto (NYSE: RTP) go through a complex dance with the major steel manufacturers in Asia, attempting to set the best benchmark price they can for iron ore shipped by sea. Negotiations begin well before the contract date of April 1, with miners attempting to get the highest prices they can, while steel-makers try to keep prices as low as possible. Eventually, one of the ore companies and a large steel-maker in either Japan or China arrive upon a price that neither is completely happy with, and that price serves as the benchmark for other negotiations.

This is how things have gone for the past 40 years. Until now.

This year, tentative deals announced around March 21 signaled the end of traditional benchmark pricing on yearlong contracts. The Financial Times quoted a senior executive involved in the negotiations in Japan as saying, "There is an understanding on both sides to move to quarterly pricing. The negotiation is no longer about annual contracts."

By March 30, the benchmark pricing system was officially declared dead, and the market turned its attention to figuring out who would profit in this brave new world.

 

The New System

Before we determine who might gain from this change, we should first look at exactly what the change is.

The new system consists of shorter, quarterly contracts that are linked to an average of the spot market. (Currently, the spot market is estimated to handle approximately 10 percent of all iron ore transactions.) With quarterly contracts, iron ore prices will track spot prices more closely, rather than being disconnected from the commodity's ever-changing supply and demand picture.

The Financial Times notes that each steel-maker will use its own formula to calculate the new prices. For example, the paper noted that ore priced to go to Japanese steel-makers next quarter has been calculated from the average spot price from December to February - approximately $108/ton, minus freight costs. On the other hand, Chinese steel-makers are looking at prices closer to $119/ton, because they're using the average price from the first quarter of 2010 as their reference.

It's a small difference, to be sure, but it suggests that in future contracts, huge price swings could occur in one country's contracts but not others, simply due to timing.

 

The Fallout

So what does this change mean? In a nutshell: No one is sure yet. But many analysts are predicting huge windfalls for miners, as their contract prices could swell 80-100 percent from last year's lackluster prices. Vale, for example, was stuck last year with an annual contract price of about $55/ton for the contract year ending on March 31, while the cash price for similar Brazilian ore reached $138.50/ton on Feb. 26, an 18-month high.

In the other major iron-ore-producing region, Australia, the benchmark iron ore hit a price of $153.6 a ton at the end of March. Not too shabby.

BHP, Vale and Rio Tinto have been already seeing improvements in their stock prices, as the end of benchmark pricing drew nearer: