For 40 years, many of the world’s biggest steelmakers and their suppliers of iron ore enjoyed a stable pricing system for iron ore that benefited everyone. Known as the benchmark pricing system, it set a one-year price for the raw material based on negotiations between steelmakers and iron ore suppliers. When a large steel company or group of steel companies reached a pricing agreement with one of the three big iron ore producers — BHP Billiton of Australia, Rio Tinto, the Anglo-Australian company, and Vale of Brazil — everyone else would generally follow that benchmark price for the rest of the year. Such stability made it easier for all parties to set production schedules, estimate earnings, and plan staffing and other costs.


But this year, the system broke down. Talks dragged on for 12 months, into this November, the month when negotiations for the following year traditionally begin. Why? Volatile iron ore prices, for one thing — as prices climb, iron ore producers have been less willing to commit to a benchmark price.


But there’s another, larger reason for the chaos in the once cozy market: China’s steel companies. Iron ore prices in 2009 have been undergoing sharp swings, and the temptation for some Chinese steelmakers to profit from the changes is apparently too strong to resist. When the spot market price for iron ore has been dropping below the benchmark, some Chinese mills have begun ignoring the contracted price and buying on the spot market, which doesn’t sit well with the ore producers. And when the ore price has been rising above the benchmark, some big Chinese steelmakers have started hoarding the raw material to then sell at a profit to smaller Chinese mills.


China‘s steel mills threw another wrench into the system. Even though an agreement was reached in June between Rio Tinto and steel companies in Japan and South Korea, their Chinese counterparts refused to accept the benchmark and demanded a lower price. As a result, iron ore producers around the world are no longer keen to sign a benchmark price agreement with Chinese steel mills. “No supplier will be happy with this. Who wants to sign long-term with them again?” says a senior executive at a top-three iron ore producer. “China can choose either fixed pricing or the spot market, but not both.”


But the biggest iron ore producers are not as concerned about China’s disruptions as one might at first think. They are content to sell ore on the spot market, especially if prices continue to rise over the next few years. Thus the market for iron ore, the most widely consumed mineral in the world, continues to evolve rapidly.


An Ongoing Battle

The 2009 iron ore price talks between Chinese steelmakers and the top three iron ore suppliers, which together supply more than 80% of the world’s iron ore, have been prolonged for almost a year, long since missing the self-imposed July 1 deadline without any agreement having been reached.


Shan Shanghua, secretary-general of the China Iron and Steel Association (CISA), which has been representing Chinese mills in price talks for the first time this year, refused to accept the benchmark price (which was 33% lower than the previous year’s price) that Rio Tinto set in its agreements with Japanese and South Korean steelmakers in June. He said the settlement does not reflect the true conditions of supply and demand on the international market and would cause Chinese steelmakers to incur major losses. Shan has also said China’s steelmakers want prices to be lowered to 2007 levels — in other words, 40% less than last year’s contract price with Vale and 45% less than with the Australian contracts.


That, of course, hasn’t gone down well with iron ore producers. “We are not so eager to negotiate for long-term prices with the Chinese mills,” notes another senior iron ore executive. “Actually, we are selling iron ore through the spot market.”


Unlike in other countries, China’s steel mills buy iron ore not only through the contract price, but also on the spot market. That started in 2005, when China joined the benchmark price talks, and Shanghai-based Bao Steel, the country’s biggest steelmaker, represented all of China’s iron and steel companies. The problem was that Bao Steel accounts for less than 100 big steel mills in China, leaving thousands of local small and midsized steel mills without long-term iron ore contracts. Many of the SMEs since have had little choice but to buy iron ore on the spot market, mainly from India.


“Of course we want to sign some long-term contracts with miners to ensure the iron ore supply, but if we cannot get a long-term contract, we just buy from the spot market,” says a manager responsible for international trade of a small steel mill in Hebei province. At the same time, he adds, “we don’t want to buy from the big steelmakers.”


Power to the Producers

China does indeed have clout in the iron ore business, having overtaken Japan as both a consumer and buyer of the raw material. Chinese steelmakers imported 443 million tons of iron ore in 2008, up nearly 16% year on year, accounting for more than half of the world’s seaborne iron ore shipments. Strong demand from China has also helped inflate iron ore prices over the past six years. Prices tripled between 2002 and 2008, due in part to burgeoning demand from China.


Demand for iron ore started to decline in the second half of 2008 due to the global economic slowdown, but it has rebounded this year. In September, China imported 64 million tons of iron ore, up 68% year on year and an increase of 30% from the previous month. CISA predicts that Chinese imports will account for about 70% of global seaborne iron ore shipments this year. Nonetheless, China’s clout is undermined by its inability to honor a contracted price and by its position as a buyer, not a seller.


The power has shifted to the iron ore producers and the big three are in no hurry to establish a new pricing system. Instead, for the time being, they are content to sell their ore on the spot market. In 2008, spot sales accounted for about 30% of iron ore trades in China, but spot sales have increased to 60% of all trades in 2009.


Complicating the situation is ore from India, which is sold primarily on the spot market. Although the quality of Indian iron ore is not as high as that of Australian ore, it has been commanding a higher price than the one-year benchmark price. That has encouraged the big producers to sell more iron ore on the spot market, further undermining the benchmark pricing system.


In July, BHP Billiton, the world’s largest mining company, said it agreed to sell 30% of its ore through a mix of spot market, quarterly contract and indexed pricing, breaking with a 40-year tradition of annual contracts. Although Rio Tinto and Vale have not shown any inclination to alter the traditional benchmark system, they also sold more iron ore on the spot market over the past year.


“The spot component of the pricing system will certainly increase, because floating price mechanisms, rather than long-term pricing contracts, more accurately reflect the supply and demand of commodities,” says Steven Randall, managing director of The Steel Index (TSI), a global provider of steel and iron ore reference prices. “If the spot pricing system can be used, the mills and miners no longer need to conduct negotiations every year.”


Beginning last year, Randall and his colleagues introduced TSI to the steel and iron ore industry and the financial community. TSI’s prices are based on spot transaction data submitted through secure online systems by more than 400 companies involved in various parts of the supply chain. By allowing producers to improve how — and how often — they monitor iron ore prices, the index has increased their desire for a new pricing system.


BHP is the biggest supporter of modifying the system. CEO Marius Kloppers has said he expects the industry to combine spot market pricing with fixed prices based on negotiations. “Small ore buyers favor fluctuating prices, while large steel mills want stable prices,” he noted in an earlier interview to the Chinese media this year.


“BHP would like to see the market be more transparent when it comes to pricing, thus avoiding the likelihood of pricing impasses that we are currently in the midst of,” said Kloppers. “All suppliers, including Vale and Rio Tinto, are increasing their percentages of ore sold on the spot market, and more flexible pricing is coming of age.”


China Still Wants a Benchmark

Nevertheless, CISA and Chinese steelmakers do not want to abandon current price negotiations. “Chinese steelmakers would rather work with long-term contracts,” says CISA’s Shan, because long-term contracts for ore ensure stable production.


An international trade manager of Hualing Group, a Chinese steelmaker, says last year, BHP had discussed introducing the iron ore price index to long-term contracts with many big Chinese steelmakers. That would mean the two sides would still buy a fixed quantity of iron ore, but prices would fluctuate with the spot market, or be adjusted every month or quarter.


However, steel mills in China are not enthusiastic about the proposal. “Most steelmakers cannot accept this model, because [it would] transfer all the risk to the demand side and the profit to the supply side,” says the steel mill manager in Hebei province. “If a floating price index is used, production costs would be largely under the control of ‘speculators,’ because many buyers are in the market while only three companies control 80% of the supply.”


Although it does not want to abandon the traditional price negotiations, CISA still wants more bargaining power as the world’s largest buyer of iron ore. At an international meeting in the Chinese coastal city Qingdao in October, Shan said the association will try to establish a new pricing model for iron ore imports in order to negotiate on China’s own terms rather than ‘blindly’ following agreements made between foreign steelmakers and leading miners BHP, Rio Tinto and Vale.


China has taken the first step toward establishing such a model. On August 17, CISA said it agreed with Australian miner Fortescue Metals Group reduce the price of iron ore between 35% and 50% from last year’s level for the second half of 2009. The price is a discount of about 3% on what was agreed between other Australian producers and non-Chinese steelmakers. “The agreement with Fortescue was, in fact, meant to send a message: China has other options besides Rio Tinto and BHP Billiton,” a CISA participant at the talks comments.


But it is unlikely that other iron ore companies will agree to the same price. Fortescue is a relatively small player. Through the second quarter of 2009, Fortescue sold 35 million tons of iron ore to Chinese companies, or 5% of China’s total ore imports. In contrast, Rio Tinto and BHP together supply more than 35% of China’s imports. “Therefore, it is unlikely that the top three miners would use the Fortescue price as a benchmark,” says Hu Kai, an analyst from Umetal, a China-based website providing iron ore information and analysis.


Xu Xiangchun, director of Beijing Lange Steel Information Reseach Center, an online information provider, also reckons a unified “China price” will be difficult to achieve, partly because of the upheaval of the internal market. “On the one hand, some Chinese steel companies would rather import ore bought on contract and then resell it for more money on the spot market, pocketing the difference,” he says. “On the other hand, although the Chinese are definitely large enough as purchasers, the import market remains very chaotic because it has so many importers with different interests and goals.” 

This month, the miners reconvene talks with steelmakers to hammer out 2010 prices, even though they have not yet settled this year’s prices. But the annual tradition will be overshadowed by sellers’ demands for a revised benchmark pricing mechanism. In the meantime, the negotiations continue. “The transfer to a whole new pricing system will take some time,” says Hu.