The End is Near for Benchmark Iron Ore Prices

Based on the role that it plays in the global steel market, China is the destination for approximately 40% of the seaborne iron ore trade, meaning it is the largest purchaser of iron ore by a substantial margin. On the supply side, Brazil, led by miner Vale, and Australia, led by miners BHP Billiton and Rio Tinto, have a near corner on the market for traded ore. As such, annual contract negotiations have for the past few years involved the leading Chinese mills, often led by Baosteel, sitting down with Vale to parse out terms for the year. The prices were matched by miners and mills alike with little fuss until the 2008 negotiations.

First, in mid-2008, dry bulk rates exploded to three times normal levels amid high demand for commodities. This environment led the Australian miners BHP Billiton and Rio Tinto to demand a higher price than Vale's agreed price to account for the freight premium they offer to China by pure geography. A first nail was struck into the coffin of the benchmark price.

Furthermore, low inventories in 2007 led to a steel price spike in 2008. Correspondingly, the thinly traded iron ore spot prices jumped as mills searched for any available iron ore to fill existing steel orders. As steel mills sold their product at record prices, resentment grew among iron ore miners over lost possible profits. Grumbling turned to action when Vale stepped forward to request a mid-contract price increase from the Chinese mills. The motivation behind the request was twofold: Vale remained angry about the freight premium offered to the Australian miners, but also wanted to position itself for a price increase at the next price negotiation. There is little evidence that Vale actually expected to be successful and the goal was most likely a show of strength both to the Chinese mills and to the other miners. A second nail was struck into the coffin of the benchmark price.

When steel prices crashed in the second half of 2008, iron ore spot prices fell alongside. Once they fell below the negotiated contract price for the year, the balance of power shifted to the Chinese steel mills. Less than two months after Vale had approached the mills seeking a price increase, the tables were turned and the mills began requesting a mid-contract price decrease. Again, the move was largely posturing in preparation for the dramatic contract negotiations to take place in 2009. Now, a third nail was struck in the coffin of the benchmark price.

IHS Global Insight now believes that change is coming to the iron ore industry. For their part, the Australian miners want to move towards an index price that could reflect the latest price of iron ore. While different versions of such an index do exist, none is yet to the scale demanded by the global market. Additionally, hopes for an index price took a hit when BHP Billiton dropped its bid for Rio Tinto in the last week of November. A successful merger would have created the world's largest iron ore miner with the added bonus of an aligned interest in an index price. It is possible that next year's negotiations will bring a partial shift to index pricing, but changes are expected to take place gradually. Instead, IHS Global Insight expects that a hybrid system of benchmark and contract prices will emerge in 2009, followed by the eventual emergence of an index or futures system with the next price spike in 2011–12.

The reason for the delay is that the iron ore miners in general are greater proponents of the index price than the mills, and it is the mills that will have the upper hand until ore supply is squeezed once more. Miners have been fairly quick to shut down mines in an attempt to adjust supply to new levels of demand, but it remains a fact that with lower production targets, mills have more sourcing options than in the past.