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A spot market creates volatility and opportunity
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Saturday, 17 Nov 2012

ABC News reported that the miners and the buyers have had to adjust to fluctuating prices for their product. It has changed the way miners do business, particularly those like Fortescue Metals Group which operate on a higher cost basis than competitors such as BHP Billiton and Rio Tinto.

It's believed BHP and Rio can produce a tonne of ore for about USD 40.

FMG's cost base is roughly double that and analysts believe its profit margin was almost completely wiped out when iron ore prices dropped to SUD 90 a tonne in September.

After years in the doldrums, the mining industry finally had a renewed demand for its product. But, in 2010, the benchmark system was abandoned.

A major factor driving the move was to better reflect daily, weekly or monthly demand for the product, but when demand is low, so are prices.

Mr Dean Felton resources consultant said that the shift was mainly driven by China overtaking Japan as the world's largest iron ore importer. China prefers the spot market so they can adjust prices quickly, whereas when the Japanese were the price setters, they were quite happy to take stability over short term price gains.

Mr Keith Tan from international trading platform Platts agrees that Japan and China are fundamentally different buyers. He said that "There are 2 tracks of iron ore buyers; Chinese steel mills are on one hand while other mills such as those in Korea, Taiwan, Japan and Europe are on the other hand."

Mr Tan said that "China likes to use the spot market because they can adjust iron ore prices to suit their demand for steel, in terms of need to build infrastructure. Whereas, the other buyers are using their ore to build ships, cars or household appliances and they want a more stable price before launching a new product or line of cars."

He said that the move changed the face of the iron ore game. The iron ore market today is a vastly different world to what it was before 2010.

He added that "Immediately after the shift, most of the contracts were based on a quarterly average of the spot value, but today it's shifted to even shorter term, on a monthly or even a five to 10 day basis."

Economic strength
Mr Philip Kirchlechner resources analyst said that the spot market has simply become another indicator of China's economic health.

Mr Kirchlechner said that "Everyone likes predictability in the markets, to see stable returns and cash flows, but with China pulling back on the reins a bit now, prices are starting to jump around more and there's more anxiety in the market."

He said that "At the moment it is ok but if the market continues to down trend, people might start to realize it isn't as good as the old system, where they had their prices protected for 12 months; that protection is now gone."

The volatility was experienced recently when spot iron ore prices plummeted to USD 85 US a tonne, down from around USD 120. It forced some miners to sack workers and scale back expansion plans.

FMG cut about 1,000 jobs and delayed its growth plans in the North West, while BHP Billiton shelved its outer harbor expansion at Port Hedland.

Mr Felton said that while the spot market provides miners with short term gains, it's an issue in times of economic uncertainty. It would be different for every producer because they all have different debt levels and cash flow issues.

He said that "Someone like a Rio could probably hold out forever until the spot price improved. But take a smaller producer such as an Atlas or an FMG and they may have to shift their tonnes despite the fall, in order to balance their books."

For more than 40 years, iron ore miners negotiated a benchmark price for their product behind closed doors.

Mr Tan said that those days are long gone.

He said that "Before 2010, market information wasn't transparent; it is now very easy to tell who is buying or who is selling on any given day, along with the price, volume and when it is going to be delivered."

Mr Felton said that when negotiating short term contracts, most miners will try to include a clause allowing them to sell some of their stock onto the daily spot market if prices soar.

He said that "The big miners will generally have a flex in their contract where they're allowed to shift about 10% of their contracted stock into the spot market if prices suddenly jump."

He added that "So, if I was a producer and I had a contract price of USD 120 and the spot price went to USD 150, I would take 10% out of my contract and put it on the spot market, so it does allow for flexibility that didn't exist before."

Mr Felton said that he believes speculation is starting. Iron ore has never really been a speculative market but I think that's going to increase and you may see it go the way of oil where speculators de-link the price from the physical.

He said that "It's not an iron ore miner, it's a Goldman Sachs, for example, which believes iron ore shares are going to go up, so it buys today because they're cheap and then sells it when it can make a margin, without actually touching the ore."

Mr Tan said that while he's yet to notice any major shift towards this, it's a real possibility. You might see hedge funds or retail investors trading iron ore swaps which means people who are not involved in the iron ore business are starting to dabble in it.

But, for now, he added that the transition to shorter term pricing was an inevitable change. If you look at other commodities, like energy, oil and so on, they've evolved over time.

Source - ABC News


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