Iron Ore's Pricing Dynamics Offer Insight

by: Markos Kaminis

Iron ore's pricing dynamics are complex, but recent industry efforts to change to a quarterly benchmark, and China's reaction, may offer insight into future commodity prices.

Rio Tinto (RTP) announced on April 9, 2010, that it was negotiating with customers to alter its iron ore pricing schedule to a quarterly benchmark, versus historical annual price setting. This follows recent successful negotiations by Vale S. A. (NYSE:VALE) and BHP Billiton (NYSE:BHP) with their Asian clients. The success of its rivals' negotiation efforts provided significant incentive to Rio Tinto, as margin and return on capital comparisons would have otherwise diverged.

Industry shares rose on the news that all major players were united in a strategic direction. The shares are already significantly higher since last year's lows, as investors had anticipated economic recovery and longer term improvement in pricing and returns.

Iron ore prices have more than doubled since September, leaving miners producing at depressed price levels that were set at now irrelevant marks. Still, steel fabricators argue that end-product demand has yet to pick up, and that higher pricing ideas are premature.

While the ore producers are price-takers, due to the economies of scale of large steel producers and the bully dealing of China, there is also truth in the steel side of the argument. If steelmakers cannot justify higher costing raw materials purchases, via sales leverage gained on fixed costs, then commensurate price increases to their end clients would be necessary to not only preserve profit margins, but to basically cover ongoing operations.

In an environment where demand is lacking, such hypothetical price increases could even serve as a quelling factor to an already struggling economic recovery, because while it's true that everything has a price, it's also true that not everybody can afford every price. Thus, the survival of weak industry participants would be in question.

If End Demand Is Not Driving Ore Pricing, Then What Is?

Chinese "hoarding" at perhaps perceived bargain basement pricing may be partly to blame for the rise in raw materials costs. A joint complaint filed by the US, EU and Mexico urged the World Trade Organization (WTO) to begin an investigation of China's export duties on nine commodities. The complaints illustrate how the duties unfairly support China's aluminum, chemicals and steel industries.

As domestic companies bear extra costs to export, domestic sales become extremely preferred. This can even support lower than global market pricing for basic materials sold in China. This allows Chinese steelmakers to source ore at a lower cost, which clearly creates an advantage for Chinese fabricators. In relation to this article though, hoarding also limits supply to the global marketplace, which acts as a driver of higher prices.

The Chinese defend their export duties with argument centered on production control, emission concerns and resource conservation. That last defense may spotlight another strategically inspired Chinese activity. It is well understood that China is active throughout the undeveloped world, making new friends in Africa for instance, from which it is developing necessary future resource supply. Given its exponentially growing demand for resources, we wondered if Chinese stockpiling might be flying under the radar, as the Chinese may be taking advantage of recent depressed pricing in anticipation of future price revival.

Alex Miral, Shipping Broker and Wall Street Greek Columnist, says that China has done this in the past ahead of pricing negotiations and benchmark resets. Mr. Miral's insight leads us to look for near-term stockpiling ahead of new benchmark negotiations. However, he sees little sign of increased shipping activity in the Capesize sector that might evidence current Chinese stockpiling. The reason China may not be stocking up now is because the Chinese are significant enough and bold enough to exact whatever price they like. When the price falls, the Chinese ignore contracted prices and pay spot, and when the price rises, they demand contracted benchmark be honored. This is the kind of thing that drives the US Congress crazy, and leads Treasury Secretary Geithner to give thought to a less accommodating trading stance.

Miral advises us that Chinese urbanization is a significant medium- to long-term driver of ore demand, and supports the price as well. Indeed, beyond devious factors, more conventional economic aspects have played a role in the rise of materials prices. Trader and speculator anticipation of economic recovery leads futures prices higher, and can also pull the spot rate a bit with it.

As we reminisce of the days of old, when the global machine was operating at full steam, a resource supply anxiety complex is rekindled, especially in certain government offices. In case you have forgotten, oil prices threatened $150 per barrel at the height of economic euphoria, and since we have rounded the economic corner, many institutional investors are thinking ahead and buying some more.

Pricing Dynamics as a Predictor

While we have ironed out the dynamics for current iron ore pricing, might current events also offer insight as a forecasting tool for commodities on the whole? Surely, iron ore producers will benefit significantly in the near-term from renegotiated pricing, but is there another incentive for the ore producers to seek more dynamic benchmarks?

If nearly all the iron ore industry participants are seeking quarterly contracts now, that implies broad expectation for price rise. Likewise, if China is now seeking to retain annual benchmarks, that would also imply Chinese expectations for price rise through the quarters of contract.

I'll refrain from recommending specific stocks based on this inference, since the values of the individual iron ore and steel producer securities may already reflect the investment theme. That kind of analysis would require a follow up article that considers security valuation. However, I think we can use the industry expertise outlined above as a guide for commodity investment favoring upside.

Disclosure: No positions