Fundamental Shift in Iron Ore Market Has Begun (Part 2)

by: Proactive Investor

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As beneficial as these price increases are for miners, inevitably they will have the opposite effect for those who are paying them, i.e. steel producers. The new system will mean steel producers are paying higher prices for iron ore, at least when markets are rising, than would have been the case under the annual agreements.

Some analysts have in fact estimated that steel prices may rise by as much as a third, as these quarterly negotiations begin to take hold. Although this will increase their costs and lower profits, it is expected most of the increase will in fact be passed along to the end consumer, with steel prices likely to rise in line with iron ore.

This increase is itself another key effect of the new contract negotiations. Increasing the cost of steel will eventually filter through to prices of all end products for which it is a raw material. In car production for example, steel is one of the main costs of production as far as raw materials are concerned. Any significant increase in steel prices will raise costs for auto makers, and eventually raise the price of cars for the end consumer.

Aside from the obvious problems this causes those at the end of the production chain, both for those selling steel and those producing goods that depend significantly on steel, the impact on the broader economy may in fact be much more widespread.

With the global economic recovery still in what many would class as a ‘fragile’ stage, this sharp, quick switch and the subsequent revenue changes for some of the world’s largest companies, may place sustained growth at risk. On a simplistic level, one could argue that the loss in revenue to steel producers would be offset by that gained in iron ore mining.

However the increase in prices through the production chain, may hinder one of the key drivers of economic recovery, as end product price hikes reduce consumer demand. If we take car production as an example, this sector has been one of the worst hit during this recent recession, as is natural for a high end product such as cars, in times of economic contraction. The recovery in this sector is still seen lagging somewhat across the US, Asia and Europe. If car prices were to suddenly jump because of an increase in raw material prices, demand may falter and the fledgling recovery would be at risk.

Looking from a broader perspective, an increase in raw material costs and the resulting rise in prices is itself placing inflationary pressure on an economy. The full implications of this go far beyond the scope of this article, but suffice to say the potential to hurt the economy comes as a direct consequence, as well as the broader domino effects spanning almost every market. It should be noted however that the use of a more fluid pricing system, for the most part, will just hasten price changes that would have come through eventually anyway.

A consistent rise in iron ore prices, such as the one seen during the recent economic recovery, would have eventually come through at the annual price fixing under the previous system. The new quarterly negotiations simply bring this move forward, although will add some volatility as they feel the impact of more short-term price swings.

One final thing to consider when looking at possible implications of these recent moves in the iron ore market, is the potential for it to lead to a more complex and liquid derivatives market, mirroring other exchange traded base metals around the world.

Historically, there have been several examples of commodities which were predominantly fixed price, moving to more flexible pricing linked to a spot rate and eventually leading to the formation of complex derivatives contracts. The crude oil market during the late 1970’s for example underwent a similar transformation in pricing, and now the crude oil market has one of the most highly traded, globally significant derivative markets across asset classes.

The aluminum market in the early 1980’s is another example where the emergence of flexible pricing, allowed a strong derivatives market to form, with all the benefits and costs that brings. Again the full implications of a developed derivatives market go far beyond the scope of this article, spanning from the ability of producers and consumers to hedge against risk, the increased global liquidity in the market and the increased price volatility it, along with speculators, will bring.

As highlighted at the beginning, the full extent of these implications and the time frame we will see them over, is not certain. The stonewalling from China is still a significant hurdle for the market to overcome, to realise the full potential of the new flexible pricing policy. However, one can be certain that these moves, many years in the coming, represent a fundamental shift for the iron ore market, the ramifications of which are likely to be felt for decades to come.

Disclosure: No positions