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As Rio Tinto (RTP) confirms it will be joining BHP Billiton (NYSE:BHP) and Vale (NYSE:VALE) in pursuing quarterly iron ore contract negotiations, the world’s three largest iron ore producers bring a fundamental shift in the industry, away from the forty year old system of annual agreements. This has ramifications spanning global commodity and equity markets, the world’s major economies and individual end-consumer alike.

Needless to say the full extent of the changes will take time to filter through; with pros and cons depending on what side of the market you fall. One thing is for certain, the structural shift away from benchmark pricing will have a wide reaching impact across asset classes and countries.

To assess the impact of these new quarterly negotiations we must first consider the previous system.

Traditionally, iron ore prices have been negotiated between miners and steel producers once a year, where the first deal between the two groups would act as a benchmark for the wider industry, effectively setting one price for the year. Concurrently a spot market was (and still is) in place, which although much smaller than the annual market, played a key role and in fact brought about the necessity for a fundamental change in the system.

The key problem with the annual system was the emergence of significant discrepancies between the benchmark price, negotiated once a year, and the free floating spot rate. The annual negotiations effectively locked miners into one price for twelve months, at what was deemed a ‘fair’ price at that time. If however iron ore appreciated in value, with gains being made in the spot market, miners would be selling their product for a much lower value than it was originally priced.

This forgone revenue has been a significant area of contention for many years, with major iron producers arguing for a ‘fairer’ system as with other metals markets. Now of course this could be argued the other way round; if prices were falling (as in recent years for example) the iron miners would have locked in a higher price than the market rate.

Empirically however this did not always pan out. Steel producers would often renege on their original agreement and buy their raw materials at the spot rate, leaving their costs lower. In this way, the benefits of the ‘locked’ price were very much one sided in favour of steel producers, and allows us to see the first effect of the new quarterly agreements; increased revenue and profit for iron ore producers.

Allowing miners to negotiate iron ore contracts quarterly means the price of their product, and hence revenue and profit based on those prices, will be moving in a much more synchronized fashion with the floating market rate. They will no longer be bound to a price set when market conditions were different, and instead will be able to renegotiate their contracts based on prevailing market conditions.

With metals prices climbing steadily across the board as the global economy emerges from recession and begins its recovery, miners will now be in a position to take advantage of the increasing prices for their product. Although specific details surrounding the individual negotiations are somewhat limited, we can take negotiation with Japanese steel makers as an example. The Brazilian miner negotiated a 90% YOY increase in prices with Japanese steel makers, agreeing to a price of between $100 and $110 per tonne of iron ore for the quarter starting April 1st.

With demand for iron likely to remain stable despite this price rise, particularly as industrial production ramps up as economies bounce back, miners are set to reap the benefits of the new methodology in this year’s bottom line. The Financial Times for example reported one executive, who estimated the individual benefit of these new prices for Rio Tinto, BHP Billiton and Vale, would be a $5 billion each in this year alone.

At this stage it is worth noting however that although agreements have been made with most Asian countries, China as yet is still insisting on annual agreements. Although negotiations are ongoing between the three largest iron miners and Chinese steel producers, a move to quarterly agreements with the number one global steel producer, would undoubtedly strengthen the benefits of the new system as far as iron producers are concerned.

Disclosure: No positions

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Source: Fundamental Shift in Iron Ore Market Has Begun (Part 1)