Iron ore derivatives set to “take off”

An interesting example of how our financial system works is playing out before our eyes. And it reveals a likely future for peak oil.

Yesterday buyers and sellers of a basic physical commodity, iron ore, announced that they had agreed a new approach for setting prices.

The changes had two main parts. First, prices will now be set to cover a three month period instead of a year (using formulas based on average spot market prices). And second, the price will now include delivery to a port in the buyer’s country, rather than the buyer having to take on the cost and risk of delivery.

The initial results of these changes are expected to be a $5bn increase in profits this year for the three largest producers of iron ore, and increased regionalisation of a previously global market.

So why have these changes come about? First, China’s “voracious” growth in demand for steel over the past 10 years has shifted the balance of power between iron ore buyers and producers — supply no longer exceeds demand, at least locally. Second, negotiations last year to reach new agreements on annual prices reached stalemate, and this change follow on from that. And third, during the financial crisis last year some steel mills refused to honour their contracts, buying instead more cheaply on the spot market — which behaviour can’t have encouraged the producers to re-enter similar deals.

So, although as Lex points out, longer term contracts can be better for both supplier and buyer because they bring predictability for both partners, for the moment this ‘symbiotic’ relationship has broken down and producers are choosing profit over reliability.

This is not the end of the story, though.

The move to shorter contracts means that prices will be able to fluctuate more rapidly. This volatility makes the market more attractive to speculators.

The follow-up story is that banks and brokers are now “gearing up to exploit the new … pricing system” by “developing a multibillion-dollar derivatives market similar to the ones that exist for commodities such as oil, aluminium and coal”.

Historically, the amount of traded iron ore derivatives (by weight) has been around 5% of the physical market (as shown by the chart in this article, although a later leader in the FT on 1 April said that “the spot market … amounts to somewhere between 10 and 25 per cent of trade”.) That is now expected to grow to reach or exceed the size of the physical market within 10 years.

In some ways this is good news for the iron-ore buyers and producers. It will allow those who wish to to regain some of the stability of the old pricing system by buying- (or selling-) forward from (or to) speculators.

But I am reminded of the story of The Great Hargeisa Goat Bubble which describes how a ‘goat derivatives market’ in Somalia came to destabilise the market for physical goats. (Also available as a Radio 4 play.)

In 10 years time (which not long really — it is a world that I expect to be living in) the size of the virtual iron ore market is expected to exceed the size of the real iron ore market. Prices will not only fluctuate in response to short term events in the physical world, but also in response to relative numbers of buyers and sellers of iron ore derivatives, which in turn will depend on the relative returns they can get from this market or that for oil, aluminium, coal, stocks and shares, government bonds, and so on. Spot prices for real iron ore contracts will depend not just on supply and demand for steel, but also on financial markets. A small change in prices driven by differences in supply and demand of physical iron ore will be amplified by speculators seeking to make profits from iron ore derivatives, which in turn will affect the price of physical ore. Instead of achieving stability by negotiating agreements with each other, buyers and sellers who want stability will now have to negotiate with brokers and banks — and pay a commission for the privilege, to bankers and brokers who will be making profits from the predicted “extreme price volatility”.

The current situation is that the price of iron ore has pretty much doubled, overnight, and is expected to rise further over the summer. The shift to ‘landed’ prices means that producers’ profits are significantly affected by transport costs, so markets will be increasingly driven by the local balance of supply and demand — which again encourages prices to rise.

Price rises for iron ore are already being passed on by steel producers: “the cost of the benchmark hot rolled coil steel is likely to hit $725-$750 a tonne by the end of next quarter, up from $550 in January, [and] as low as $380 a tonne last year.” And steel prices will then “inevitably” have a “significant impact on prices through the whole value chain down to the end consumer” — in canned food, cars, oil tankers, steel framed buildings, railways, power stations, …

These impacts have arisen not from any great shortage of iron ore, but simply from a change in the way contracts are negotiated. And the new system that has been put in place makes higher prices and higher volatility of those prices more likely.

This does not bode well for what will happen to the price of oil, and its knock-on effects, when global demand exceeds supply, “within the next five years“.

Footnote

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Financial Times, “Steel prices set to soar after iron ore deal”, 30-31 March 2010:
http://www.ft.com/cms/s/0/d15d7758-3bad-11df-a4c0-00144feabdc0.html

Financial Times, “Iron ore swaps could grow to $200bn”, 30 March 2010:
http://www.ft.com/cms/s/0/c6dd3ada-3c1a-11df-b40c-00144feabdc0.html

Financial Times, Lex, “Iron ore pricing”, 30 March 2010:
http://www.ft.com/cms/s/3/a49ed476-3c04-11df-9412-00144feabdc0.html

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