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June 1, 2009

The Iron Ore Negotiation and Impact on the Steel Industry

Dian L. Chu, 06/01/09

Rio Tinto became the first of the three big iron ore suppliers to agree to a 33% cut of the benchmark iron ore price starting April 2009 with Japanese mills including Nippon Steel as well as South Korea's POSCO. However, China bucked protocol and rejected the agreement. CISA (China Iron & Steel Association) is insisting on cuts of at least 40%, taking it back to at least 2007 levels. Rio's competitors BHP Billiton and Vale of Brazil, the leading supplier, have yet to announce any similar deals.

In the past four decades, traditional ore pricing was based upon long-term framework contracts between steelmakers and the big three miners, Rio Tinto, BHP Billiton and Vale, with annual negotiations to settle prices for 12-month periods. The secretive annual talks influence the billion-dollar ore trade market and the global economy as ore prices ultimately influence the prices of goods such as cars and machinery. Once the first price agreement is negotiated as a benchmark, then the rest of the industry follows. While the ore benchmark system has served the steel industry well, it has come under strain as China has grown more powerful in the global commodities market. Securing the benchmark price for China is significant for the miners, as China's demand for iron ore in 2008 was 444 million tons, more than half of the world's total.

The past six years have seen the ore price rise 500%. The 33% cut actually represents a premium when compared with current spot prices, which is around 40% lower than the long-term contract price. Spot iron ore prices slipped below long-term prices in late 2008 as demand from China crashed. The new agreement is actually a better outcome for the miners than analysts’ consensus of a 35-40% cut. Steel production and prices have plunged in recent months as the global economic downturn has battered demand. For the steel companies, the 33% cut, the first in seven years, no doubt will reduce costs and improve margins. As most mills long-term material supply contracts are renewed in March, analysts estimate overall cost of steel-making raw materials, including coal, may fall about 50% Y/Y, bigger than steel products price decline. In addition, crashing freight costs should also yield lower costs for steel producers everywhere.

This unprecedented split between China, and other top buyers and suppliers, is sowing uncertainty for the key steel-making ingredient. Miners believe China's 4-trillion-yuan ($586 billion) stimulus package and the new steel futures contracts might help spur steel demand. However, most steel companies believe that the global economy is still in contraction, and steel supply still outweighs demand.

Iron ore supply increased 30-40% last year as production capacity rose. Meanwhile, global demand for steel declined. CISA now expects China steel exports to fall nearly 80% this year. Although expectation of a China State-led construction boom has triggered a new round of inventory build-up, analysts do not expect an immediate pickup, as the stimulus package may just barely offset the weakness elsewhere. In addition, some steel producers, such as US Steel Corp. and Arcelor Mittal, have their own iron ore mines, while others such as Nucor Corp. make steel by melting scrap in electric furnaces. Based on market fundamentals, a recovery in the steel market is likely to be L-shaped as opposed to V-shaped. Steel prices should level off in the coming months as the economy stabilizes resulting in a surplus for global iron ore in 2009.

As a result of falling iron prices, steel producers have room to reduce prices and still maintain margins. Although majors like Arcelor Mittal indicated they would rather cut production than let prices fall. So expect resistance from the steel mills in passing through the raw material cost reductions. However, unlike the iron ore market where the top 3 miners control nearly 80% of the global seaborne ore market, the global steel industry is still highly fragmented despite considerable industry consolidations in recent years. As other smaller producers drop prices to secure sales, the majors may have no alternative. This is expected to be part of a long-term trend running through 2009. The gap between spot prices and long-term contract prices will narrow and spot prices may overtake long-term contract prices. It seems likely that system will continue to trend toward a mixture of benchmarking and indexing to the emerging OTC swap market. Another possbililty is that instead of being negotiated once a year, the iron ore contract could be negotiated on a quarterly basis next year amid the reduced demand.
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Item Reviewed: The Iron Ore Negotiation and Impact on the Steel Industry Rating: 5 Reviewed By: EconMatters