New ore pricing norm to affect margins

The potential impact of the monumental change in the pricing system of iron ore contracts cannot be underestimated as it will have ramifications for a wide cross-section of industrial sectors from construction to manufacturing.

The landmark deal by two – Vale of Brazil and Anglo-Australian BHP Billiton – of the world's three biggest iron ore producers, with large Asian steel manufacturers, to move to short-term pricing deals linked to the spot market for iron ore, has seen an immediate high increase in the price steelmakers will pay for iron ore, the main resource used to make steel. It is expected to mark the end of the benchmark annual contract system where prices were agreed at the start of the year for the year ahead, a system which has been in place for over 40 years.

The traditional iron ore pricing system, whereby the first price agreed between the miner and a major steel manufacturer at the start of the year was used as a benchmark by the industry for the year, was archaic and at times, led to cost problems for miners. However, the system gave stability and price certainty to steelmakers.

Steel is a major material used in construction, and can represent around 20 per cent of overall construction costs depending on the design, as well as in key consumer products such as motor cars and electrical goods. Accordingly, there will be a direct impact on both construction costs and costs of other manufactured goods. The market will not be able to absorb the full price increase directly due to continued weak demand and hence, construction companies and manufacturers will have to absorb some of the price increase, thereby hitting margins at least in the short- to medium-term.

Closer to fundamentals

Going forward, it would seem inevitable that the pricing of iron ore will move to at least a quarterly contract pricing basis, but will also see monthly and spot pricing contracts. This certainly produces more volatility for both steelmakers and for users of steel. However, there are also advantages, most significantly through the benefit of any fall in the price of iron ore, and greater price transparency through prices being driven by the market. Under the previous system, if there was a large fall in the iron ore price during the year, steelmakers and others could not capitalise on it. Going forward, iron ore and, in turn, steel prices should more closely reflect supply and demand market fundamentals.

Looking ahead, to protect and manage positions and costs, steelmakers will have to make use of hedging far more, in order to lock in prices of iron ore and not be hit by price volatility in the spot markets. One of the advantages of the current system was in the reliability of prices for raw materials. Although the decision to move to shorter-term pricing contracts momentous, it should be remembered than most key commodities, particularly the all important oil market, is priced on the spot market. Buyers and users of oil for example, have long used derivative contracts and hedging to manage forward positions. An iron ore derivatives market will allow producers and consumers to hedge their positions more easily in the physical commodities market, minimising price risks. On the other hand, speculators will be able to bet on the direction of iron ore prices.

Although in the short-term, iron ore prices will move higher thus placing further upward pressure on steel prices, going forward, steelmakers may well have more control or influence over iron ore prices through demand factors. The latter will in turn be influenced by economic factors such as growth and activity. If the spot market price falls due to economic factors, steelmakers will benefit more quickly. It should be remembered that the negotiations which spurred the move to short-term pricing was largely due to China refusing in early 2009 to agree to benchmark prices agreed by Japanese and European steelmakers, demanding instead a 50 per cent reduction.

Stabilising influence

The extent of influence may however be somewhat limited by the fact that the world's three major iron ore producers, Vale, BHP Billiton and Rio Tinto, control over two-thirds of the global market. This fact has already been noted by authorities, including those in Europe and the US and, backed by steelmakers, authorities may well investigate the competition within the iron ore industry and could well take steps to break the dominance of the market by the three major miners.

For the regional steel market, price increases cannot be avoided. The Gulf Co-operation Council (GCC) steelmakers, led by the major producers in Saudi Arabia, UAE and Qatar, are generally cost-efficient, aided by lower energy prices, but have experienced weaker demand over the past 18 months due to the global economic downturn, particularly the fall in construction activity. However, the low demand has kept local steel prices comparatively low. Looking ahead, construction costs will be higher as raw material prices move up. At the same time, higher steel prices and other raw material costs will help to stabilise prices for current developments in the property sector.

A big question over the new price arrangements for iron ore and hence steel is the impact on the economic recovery and if higher costs will restrict it. Though the increase will not knock the global recovery off its ultimate path, persistent higher increases will impact the manufacturing and construction sectors and reduce demand for price-sensitive products, causing weaker than expected growth prospects.

- The author is a US-based commentator on business issues. The views expressed are his own

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