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After being labeled as a savior and a threat to the world’s steel industry, China is slowly pulling back on its steel production after restarting a war of world's over setting up the prices for China's biggest import commodity. The China Iron and Steel Industry Association (CISA) has suggested that iron ore prices should be linked to steel prices instead of iron ore indexes while top global Iron Ore majors including Rio Tinto Group (RTP), BHP Billiton Ltd.(NYSE:BHP) and Brazil's Vale SA (NYSE:VALE) ended a 40-year custom of setting annual prices in favor of quarterly agreements.

Difference Over Iron Ore Pricing

The Chinese Steel Industry Association argues that the current iron ore pricing system that is based on price indexes reflects only a small portion of the iron-ore trade that passes through the spot markets, and therefore should not be the determinant of sea borne iron-ore prices while Iron Ore majors including Rio Tinto Group, BHP Billiton Ltd. and Brazil's Vale SA, which account for three-quarters of global iron ore trade, ended a 40-year custom of setting annual prices in favor of quarterly agreements as they bet on rising prices.

Even as the war of words continue to mount, Jose Carlos Martins, head of ferrous business for Vale SA, told an industry conference that iron ore pricing indexes including spot and benchmark iron ore prices were also converging acknowledging that Asian steel mills still prefer a quarterly pricing system.

Tensions peaked last year when CISA failed to clinch an annual pricing deal and a Shanghai court jailed four Rio Tinto employees, including Australian citizen Stern Hu, for stealing commercial secrets and taking bribes. Their arrest at the height of fraught term iron ore price negotiations in 2009 strained ties between Australia and China, and shocked the Chinese steel industry.

Meanwhile as the price wars begin to develop into a serious difference of opinion, China, the largest buyer of iron ore, is considering recycling the scrap metals to reduce steel makers' import dependence. Iron ore sold by BHP and Rio will post their first price decline as a result in three quarters as automakers and builders in China cut orders for steel.

China, the biggest buyer of the raw material used in making steel, expects to lift iron ore production by about a quarter to more than 1,1-billion tons this year and cut imports as it tries to rely less on the global miners. CISA however says that while domestic steel prices will remain volatile in the near term, demand should pick up in the fourth quarter because of the growing Chinese economy.

Uneasy China-Australia Iron Ore Equation

China has been long pushing for a more favorable iron-ore pricing system, and has even warned that it would not pay more for costs arising from any looming Australian mining tax. The statement comes after local media reports that Australian iron ore costs could rise because Australian Prime Minister Julia Gillard has proposed a 30 % tax on coal and iron ore mining profits from 2012. Australia is China's top source of imported iron ore and a major investment destination for Chinese companies, including steel mills, many of which have stakes in iron ore mines there.

Though China has taken steps to curb steel production in the short-term, it seems unlikely that the country will impose any longer-term cuts in output. China has boosted its own iron ore production in the last five years in a bid to displace some of its imports even as Iron Ore major and Chinese Steel Industry brace themselves for a mutually acceptable agreement.

Steel ETFs in Focus

For investors looking to make a play on the global steel market, there are two ETFs to play the steel industry directly. Both of the funds below hold the stock of companies involved in steel production; there’s currently no physically backed or futures-based steel ETF.

  1. Market Vectors Steel Index ETF (NYSEARCA:SLX): The Index provides exposure to publicly traded companies primarily involved in a variety of activities that are related to steel production, including the operation of manufacturing mills, fabrication of steel products, or the extraction and reduction of iron ore.

Data as of 2010-09-03

SLX Top Ten Holdings

  1. Vale S.A. ADR (VALE): 12.40%
  2. Rio Tinto PLC ADR (RTP): 10.97%
  3. ArcelorMittal (NYSE:MT): 9.36%
  4. Posco ADR (NYSE:PKX): 6.04%
  5. Gerdau SA ADR (NYSE:GGB): 5.74%
  6. Companhia Siderurgica Nacional ADR (NYSE:SID): 5.11%
  7. Reliance Steel and Aluminum (NYSE:RS): 4.77%
  8. Gerdau Ameristeel Corporation (GNA): 4.76%
  9. Allegheny Technologies Corp. (NYSE:ATI): 4.73%
  10. Nucor Corp. (NYSE:NUE): 4.67%

Expense Ratio: 0.55%

  1. PowerShares Global Steel Portfolio (NASDAQ:PSTL): The Index is designed to measure the overall performance of globally traded securities of the largest and most liquid companies involved in the manufacturing and storage of iron and steel products.

Data as of 2010-09-03

PSTL Top Ten Holdings

  1. Posco: 8.37%
  2. ArcelorMittal (54140): 7.82%
  3. Companhia Siderurgica Nacional (CSNA3): 6.70%
  4. Nippon Steel Corp. (5401): 6.20%
  5. JFE Holdings, Inc. (5411): 5.09%
  6. Kumba Iron Ore Limited (NYSE:KIO): 4.34%
  7. ThyssenKrupp AG (TKA): 4.09%
  8. China Steel Corporation (2002): 3.44%
  9. Nucor Corp. (NUE): 3.30%
  10. Fortescue Metals Group Ltd (FMG): 3.22%

Expense Ratio: 0.75%

Disclosure: No positions

Source: Demystifying China's Iron Ore Price Negotiations