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Unlike most commodities, the majority of iron ore trades under benchmark contracts in which major counterparties negotiate annual changes in prices. This system often takes months to reach a final resolution. Vale, the world’s largest iron ore miner, is first in line to fix iron ore annual contract prices, followed by Rio Tinto, and BHP Billiton. These three dominate the seaborne iron ore market.
Iron ore is priced in U.S. dollars. A unit pricing system is used to adjust for variations in iron content. A unit is 1% of the weight of a ton of iron. A buyer that purchases 1 ton of ore that is about 65 per cent iron is paying for 1 ton of iron contained in that ore and will receive roughly 1.5 tons of ore.
Iron ore product prices are differentiated between lump (premium) and fines. After more than twenty years of trading between 0.22 and 0.40 cents metric ton unit, iron ore prices began to move up in 2004. Prices surged upwards in 2005, and this year has seen unprecedented settlements in terms of value and percentage escalation.
Recent events in iron ore price negotiations between the three largest iron ore producers and the world’s major steel manufacturers has caused many to assert that the benchmark contract system may soon be replaced by an index spot price system. BHP Billiton is already actively pushing for this shift in pricing systems.
One major benefit of an over-the-counter pricing system is a more transparent market, according to BHP CEO Marius Kloppers. “I think that over the next couple of periods, we will see a greater transparency in physical markets developing to augment the traded market,” said Kloppers. “And I think those two things need to come together to really give us accurate price discovery going forward.”
The company believes the “situation is largely irreversible” and does not wish to enter into any new term iron-ore contracts based on the benchmark system, preferring instead to sell against the burgeoning index spot market.
Although the spot market trade will continue to grow, it will not replace term contracts anytime soon. The market will need much more liquidity before it can replace the benchmark contract system, which will likely remain prominent for at least another decade.
