On March 23, during a tea break at the 2011 China Iron Ore Conference, several ore traders sipped coffee and chatted casually.
A year earlier at the same conference, Wu Rongqing, Chief Engineer of the Industrial Development Department of the China Mining Federation, had openly criticized Vale (VALE) for forcibly implementing an indexed pricing mechanism, with sharp words.
In February 2011, Luo Bingsheng, who stepped down as Executive Vice President of the China Iron and Steel Association (CISA) due to age limits and was reassigned as a special analyst, frankly admitted at CISA's routine quarterly information release that the iron ore pricing system had already become fully indexed. This statement was interpreted as meaning that after a year of trial operation, the indexed pricing system for iron ore had been recognized by the Chinese side, officially establishing the new pricing mechanism.
"In another week, it (the indexed pricing mechanism) will be one year old," Rio Tinto CEO Tom Albanese recently told Caixin reporters during the China Development Forum, saying it was a good time for evaluation.
The Pain of Pricing Transition
After a year of trial operation, the new pricing mechanism based on iron ore indices, with quarterly cycles, has been widely accepted, but demand-side players have suffered from the troubles of the mechanism shift.
New quarterly contract prices are determined in the first month of the previous quarter, with price levels being the weighted average of the iron ore index prices over the past three months. Currently, there are mainly three globally influential ore indices: Platts' IODEX index, the TSI index under Steel Business Briefing (SBB), and Metal Bulletin's MBIO index.
"Now doing ore business is getting harder. The quarterly price is more closely tied to the spot market compared to the annual price, leaving little profit margin," said a responsible person from a private steel enterprise’s ore trading department to the reporter.
This responsible person mentioned that his company imported around 8 million tons of iron ore last year, supplying part to their own steel mills and selling the rest to some small nearby steel mills. "After the pricing mechanism transition, the profit margin of traders has been further squeezed, which actually benefits the miners," he expressed helplessly, "With ore prices rising continuously, our own steel mill's cost pressure is also great. Now domestic traders and steel mills have little profit margin."
Data from United Metal Network showed that since the start of quarterly pricing, import prices for Brazilian ores rose by 97.60% in the second quarter of 2010, reaching $132.02 per tonne CIF, while prices in the third quarter increased further by 31.48%, reaching $173.58 per tonne CIF. After a 10.78% correction in the fourth quarter, prices rose again by 7.39% in the first quarter of this year.
This reduced China's enthusiasm for importing iron ore. According to statistics from CISA, China produced nearly 627 million tons of crude steel in 2010, up 9.26% year-on-year, while importing 619 million tons of iron ore, down 1.4% year-on-year. This was the first year-on-year decline since 1998. Among major countries, apart from a 1.3% increase in imports from Australia, imports from Brazil, India, and South Africa all saw significant declines, with imports from Brazil dropping 8.1% compared to 2009, South Africa down 13%, and India down 10%, all exceeding the overall average decline of 1.45%.
Tom Albanese told Caixin reporters that "quarterly pricing is calculated using the index method, a pricing system between long-term contracts and spot prices, more balanced. We are satisfied with this pricing method; it is a transparent system."
A Japanese trading company executive told Caixin reporters that since last year's pricing mechanism change, due to Japanese steel companies signing steel price contracts with downstream enterprises for half a year or a year, they found it difficult to accept the mechanism change. He disclosed that since 1998, Japan's trade agents' fees for iron ore began to decrease, and the change in the pricing mechanism increased the proportion of iron ore imported directly by Japanese steel companies, compressing the space for traders. In 2010, Japan's trade agents' income from imported iron ore was only one-third of what it was before 1998.
"But considering the current supply and demand situation, this mechanism is relatively fair and cannot be changed in the short term," the executive said helplessly about the current tight supply and demand situation.
Luiz Meriz, President of Vale China, said on March 23 that due to no new large-scale iron ore projects starting, the supply of iron ore would continue to be tight in the next few years. He predicted that by 2015, Vale's iron ore production capacity would reach 522 million tons.
Relying on a good outlook for future ore markets and locking in shipping costs to enhance the market competitiveness of its ore products, Vale started rebuilding its shipping department in 2007. In 2008, Vale spent $1.6 billion ordering 12 400,000-ton ultra-large ore carriers and announced the next year it would lease four ships of the same class from Oman Shipping Company. Additionally, Vale ordered four 180,000-ton cape-type vessels. Including the currently owned 20 cape-type vessels, in the future, the Brazilian mining giant will possess a vast shipping force composed of large vessels.
Zhu Kai, who was promoted to Global Sales Director of Vale last year, revealed to reporters that the first 400,000-ton ore carrier would be delivered soon, and the entire fleet is expected to be basically established by the end of next year.
From the Australian mining side, Sam Walsh, CEO of Rio Tinto's Iron Ore Group, stated on March 24 that Rio Tinto was pushing forward a nearly $15 billion investment plan for the largest integrated ore development project in Australia. By 2015, Rio Tinto's annual supply capacity in Western Australia would reach 333 million tons.
BHP Billiton also recently disclosed its investment plans for iron ore-related businesses in Western Australia on its website. By 2014, the company would form an annual supply capacity of 240 million tons of iron ore in Western Australia.
Still in the Transition Phase
The completion of the pricing mechanism change and the good expectations for the future ore market did not completely relax the miners.
Roger Agnelli, CEO of Vale, said in a media interview in Shanghai that "the quarterly iron ore pricing mechanism looks good so far, at least this mechanism is functioning normally, but it needs to be consolidated, and the consolidation process requires time."
The consolidation Agnelli referred to originated from the doubts raised by the ore demand side regarding the representativeness of the index. CISA believed that the current iron ore price index formulation was unfair, and pricing according to this index favored the miners while harming the interests of steel enterprises. Global iron ore seaborne trade volume has exceeded 1.2 billion tons/year, while the spot market for fine ore in China's coastal ports, where the three indices collected price samples, has a market capacity slightly higher than 100 million tons, accounting for approximately 10% of global ore seaborne trade. Using the spot market price with a weight of one-tenth to establish a global iron ore trade price benchmark is clearly unacceptable to Chinese steel companies as major buyers.
The above-mentioned Japanese company executive also acknowledged this view. He indicated that the sample size was too small, and using China's market prices to determine global iron ore prices was unreasonable. Moreover, he pointed out that the current method of collecting samples via telephone lacked transparency.
"The pricing mechanism is constantly evolving. It is currently in a transitional phase. The index method was a supplement to long-term contracts in the past few years, and the transaction volume realized through the index method was very small. Whether the index method can adapt to large-scale transactions is a question. That's why we're sitting down to talk now," Alan responded to the doubts from the demand side.
Rio Tinto said negotiations would continue, but the current negotiations were centered around the index, discussing whether the index pricing method was reasonable and whether each company's index scientifically and effectively reflected the needs of all parties.
Vale took a very open attitude, stating it could discuss ways to further improve the new pricing mechanism with customers.
Chinese steel information agencies have been monitoring the spot market prices of China's iron ore for many years, and CISA has begun attempting to establish an official price index representing China's iron ore demand to replace the currently used three major indices (related reports see Issue No. 24, 2010 of Caixin, "Iron Ore Index Pricing Trap").
"As long as there are sufficient facts proving the superiority of the new index, we don't care which index the customer chooses for price settlement, but the premise is to ensure the fairness and consistency of index selection," Zhu Kai said.
Bao Yi'an then stated that the evaluation of the current index was ongoing, "We support the solutions supported by our customers." In email exchanges with Caixin reporters, Rio Tinto expressed two points: First, the current quarterly pricing runs well and is accepted by customers, and Rio Tinto does not seek to shorten the pricing cycle to monthly. Second, if any customer proposes the intention of more frequent pricing, Rio Tinto is willing to discuss and reach agreements with customers.
As a strong promoter of the pricing mechanism transformation, BHP Billiton is not content with merely shortening the pricing cycle to quarterly. Starting from 2011, it decided to implement a monthly pricing mechanism for most of its iron ore exports, changing the previous global quarterly pricing system. Quarterly pricing was originally proposed by BHP Billiton.
Industry insiders generally believe that replacing the traditional annual agreement pricing with an iron ore index-based pricing mechanism is not just a conversion of pricing mechanisms but also paves the way for the financialization of iron ore.
In 2008, Deutsche Bank and Credit Suisse first ventured into the iron ore derivatives market, launching iron ore swap contracts. Currently, multiple exchanges, including the Singapore Commodity Exchange and the Chicago Exchange in the U.S., provide iron ore swap settlement services.
On January 29, India launched the world's first iron ore futures, but trading volume was limited. On March 28, the Singapore Exchange announced plans to launch iron ore futures in early May, having received regulatory approval. Analysts said that although the initial trading volume in the iron ore futures market was limited, it provided a platform for financial capital to enter this commodity trading sector, endowing iron ore trade with stronger financial attributes.
Alan worried that index pricing might become a tool for financial institutions to develop derivatives, "and these derivatives are seeds of crises."
Jose Carlos Martins, Executive Director responsible for iron ore and manganese ore business at Vale, also told Caixin reporters at the end of 2010 that he did not think iron ore would become a financial product, citing three reasons: First, iron ore products cannot achieve standardization; Second, the volume of iron ore trade is too massive, and its physical form makes it impossible to build inventory like oil; Third, iron ore trade is primarily direct buying and selling between miners and steel mills, with intermediaries playing a minor role. "Neither miners nor steel mills want to develop towards financialization," said Martins.
Representatives of Japanese steel companies believed that pricing should be stabilized by direct participation of suppliers and users, and the involvement of financial institutions would inject greater risks into the entire ore market while increasing ore pricing costs.
Although the supply and demand sides have not reached a consensus on how to improve the index pricing mechanism, stepping away from the previously tense annual negotiations has made the involved parties feel much more relaxed. Alan told Caixin reporters that annual negotiations were tough work for all negotiators. "You cannot find a solution satisfactory to everyone. You may spend 12 months negotiating a price, then spend another 13 months arguing about that price, which is a headache for all parties."
"For me personally, not having to negotiate anymore is a relief," Alan said.