May 23, 2008, will go down in history as a watershed for the iron ore industry. Credit Suisse and Deutsche Bank officially launched the first over-the-counter iron ore swap market, carving a path for others to follow.
Today, a handful of banks including Morgan Stanley and Barclays Capital provide the same services, while both the Singapore Exchange and LCH.Clearnet have started clearing iron ore swaps. They are joined by brokers, opening iron ore desks day after day.
It seems like a long way from where the iron ore industry was a few years ago. For decades, prices were set on an annual benchmark basis by a clique of companies and their steelmaking customers.
But surging prices and volumes in the spot market, largely driven by demand from China, exposed what many see as the need for a derivatives market. And with the leading players’ failure to establish a benchmark price this year, the iron ore spot and derivatives markets have been looming as a viable alternative.
The world’s crude iron ore resources, used in steel production, are estimated to exceed 800bn metric tonnes and contain over 230bn tonnes of iron, according to the US Geological Survey.
So with iron ore exports doubling since 1999 to 882m tonnes in 2008, according to the United Nations Conference on Trade and Development, no wonder the financial industry has worked up a good appetite for the metal.
Deutsche Bank and Credit Suisse offer cash-settled swaps across a range of maturities. They are settled every month against indices published by Metal Bulletin (part of Euromoney Institutional Investor, publisher of FOW) and Steel Business Briefing (SBB), which use Chinese spot iron ore prices. So far, over 15m metric tonnes have been traded in swaps since the launch of the service, according to Deutsche Bank.
The inauguration this year of central clearing for iron ore swaps was the next significant step for the nascent market, helping to eliminate counterparty risk.
In April, SGX began clearing OTC iron ore swaps on AsiaClear, its OTC clearing facility. It was quickly followed by LCH.Clearnet in June.
Both SGX and LCH clear the landed Chinese financial iron ore swaps based on SBB’s benchmark, The Steel Index (TSI), which looks at 62% iron content fines. The swaps are cash-settled against the monthly average of daily TSI iron ore prices in the expiring month.
The iron ore swap is a fixed-floating rate swap, fairly similar to interest rate swaps. “I might be willing to offer you a fixed rate price for a tonnage of North China-delivered iron ore over a duration period, and in return you agree to pay me an aggregated floating rate price based on a benchmark index,” explains Brad Ridge, director of product development for Asia Pacific at Icap in Singapore. Icap is one of the brokerages that provides access to SGX AsiaClear.
SGX has attracted a lot of Asian business, owing to its location and time zone. But its service is offered globally. “Counterparties that have participated in SGX OTC Iron Ore Swap Clearing include small to mid-size privately owned Chinese steel mills and shipping companies, international commodities trading houses, investment banks and producers,” says Elena Sng, vice-president of clearing and commodities at SGX.
In the April-August period, the exchange cleared over $200m of contracts, equivalent to 2.57m tonnes. The volumes might look tiny compared with the size of the iron ore industry. But SGX asserts that the service has attracted a lot of interest and the volume has been growing. In August alone, cleared volume reached 915,000 tonnes – 33% up on July and 137% more than in June.
Market participants say the majority of trades are cleared through SGX, which has benefited from its location and first mover advantage over LCH.Clearnet.
The latter does not publish its cleared volumes, but “the take-up has been slower in London,” says Steven Randall, managing director of TSI, though he is confident the volumes in London will go up.
So far, only a few hedge funds have got involved in the business, due to its insufficient liquidity. But iron ore’s correlation with freight prices is helping the liquidity pick up.
“Depending on the price of iron ore, a significant portion of the price is freight,” says Raymond Key, global head of metals trading at Deutsche Bank in London. The spot iron ore price includes both the free on board (FOB) price and the freight charges.
It is no surprise, therefore, that the new iron ore swap initiatives are more likely to originate in freight and coal departments of clearing houses, banks and brokerages. Several commodity brokers such as Spectron have set up iron ore desks as an extension of their freight or coal desks. Other brokers include GFI Group, London Commodity Brokers, Freight Investor Services and others.
“We combine steel, iron ore and freight all under one umbrella, because there is a direct relationship,” Key says.
And it is the freight people that are providing liquidity. “The client base within the group was very much already involved in bulk commodities, whether it be freight or coal or even some of the base metals, and they were also having exposures to iron ore,” explains Paul Temple, head of the iron ore trading desk at Spectron in London.
“People that trade or are involved in the freight business tend to be very clued up on the iron trade,” Key says.
Many of those who have embraced cleared OTC iron ore swaps have already been clearing freight derivatives through SGX AsiaClear or LCH, and the two groups have similar volatility exposures.
“It makes sense for an end user to risk manage their freight and iron ore exposures via a common clearing pool, especially if an exchange is in a position to provide reduced offset collateral margins,” says Ridge. “These moves are positive for the expansion of OTC swap depth and liquidity and participants’ appetite to make use of these facilities is increasing.”
What starts to occur is cross-product margining at the exchanges. “If you’ve got a long iron ore and a short freight position, they will offset each other,” Temple says.
While cleared swaps give people exposure to iron ore delivered in China, there are products that deviate from the standard swap. If one wants to have iron ore delivered elsewhere, Deutsche takes China-landed delivery product, but then strips the freight out of it if it goes to a new destination.
“If it’s an Australian product, then you’re stripping out the freight route from Australia to China… It’s giving those regions the opportunity to trade this product and minimising any of the risk,” Key says.
A changing market
The nascent derivatives market, iron ore indices and the existing spot market are just a few signs of how the iron ore industry has evolved in the past few months and years. Big steps have been taken in a fairly short time.
“If we go back more than five or 10 years ago, the iron market was rather dull from period to period,” says Calum Baker, head of research for steelmaking raw materials in London at CRU, a research and consultancy group. “There really wasn’t a great deal of spot sales activity in the market,” Baker says.
The iron ore market was settled according to an annual benchmark – decided behind closed doors in negotiations between steelmakers and miners. And the changes in price from year to year were “fairly unspectacular”, Baker says. The volatility of the last couple of years came as a big shock for steel mills and steel producers, boosting their interest in fixing the price of the metal.
From around 2004 onwards, massive growth in the Chinese steel industry and production caused demand for iron ore to surge. This applied pressure to the market, which struggled to manage. Traditional miners dominated by three big companies – the UK’s Rio Tinto, BHP Billiton of Australia and Brazil’s Vale, were not able to meet this demand so quickly.
“All of a sudden, China was having such a huge demand for iron ore that it was going out to the rest of world markets and domestically, having to buy any shipments that it could, which created a new spot market,” Temple says.
Spot market grows in strength
To fulfil their requirements, the Chinese started to buy quite a lot of iron ore on a spot basis from India and some of the smaller producers. This helped an increasingly large spot market to develop.
Today China is by far the world’s largest iron ore importer. Overall, it imported 444m tonnes of iron ore in 2008, 16% more than in 2007, according to Unctad figures.
Meanwhile, the firms mining in Australia started to supply additional volumes at spot prices, above what they had agreed in contracts.
This further strengthened the spot market. In response to calls for an independent and reliable view of spot prices, several companies created indices. Metal Bulletin, SBB and Platts compile the most visible price assessments, but their methods vary.
“We’ve almost got a sort of two tier system at the moment,” sums up Baker at CRU. “One, when the price is not especially volatile, and then another form of the market where the prices are varying from day to day based on both the FOB price of the iron ore and freight rates as well.”
Meanwhile, Wall Street and the City of London are eager for the iron industry to move to a more flexible pricing system, commoditising the product like so many others.
This would of course create lots of profitable trading opportunities for banks, brokers and funds. But these firms claim the move would help the iron industry, too.
“It [derivatives market] removes the potential for some of the more acrimonious disputes and basically allows more junior miners more freedom in price fixing and price hedging. It’s definitely a positive development and it will probably grow as well,” says Edwin Burden, coal and dry freight analyst at RBS Sempra Commodities in London.
Benchmark under attack
The benchmark system is still the dominant way of pricing iron ore. “Certainly, it accounts for at least 50% or more,” says Burden. “Whether it will continue for that much longer is open to conjecture.”
But the system has revealed its unattractive side. Negotiations have been dragging on and often by the time the benchmark is settled, the spot market is showing a wide divergence from it.
A stark divergence occurred in summer 2008 after the Beijing Olympic Games. Demand for iron ore collapsed. Prices dropped from $180.61 a tonne in July to $56.67 in October, according to Metal Bulletin figures for Qingdao-delivered iron ore.
“Suddenly the spot price just went through the floor and actually went below the long term benchmark price,” says Cameron Hunt, director of the Iron Ore Index Project at Metal Bulletin. “When the market collapsed like that, nobody wanted that material any more. They just walked away from it.”
As a result, some buyers of ore defaulted on their contract obligations or delayed tonnage. A lot of the small miners got burnt really badly.
“There was no protection at all; there was no risk management in there,” Hunt says. “That’s where suddenly the thought of swaps and financial trading and risk management has become much more exciting, because this period of September, October and November last year really brought it home to the physical players their risk management wasn’t worth anything.”
This year has been especially difficult and contentious, with a breakdown of price negotiations between China and the big miners. Then in July, the Chinese authorities detained four Rio Tinto executives, apparently as part of an investigation into bribery and stealing state secrets. As of October 1, the one Australian citizen and three Chinese were still locked up.
This event was the nadir of an arduous benchmark-setting process this year, and is likely to have strengthened the feelings within the Big Three producers that lean towards finding new methods of pricing.
“This year, we’re seeing a greater use of the spot market than pretty much ever before,” says Kimberly Leppold, senior metals analyst at Metal Bulletin Research, based in Philadelphia.
Moreover, some of the biggest miners, which traditionally preferred the benchmark system, have started to sell a share of their resources on the spot market. They include Rio Tinto and BHP Billiton. Even Vale, the biggest of the Big Three and known to be a vigorous proponent of long term contracts, has been doing some spot sales this year.
Prospects for the industry look rocky. As sectors such as construction, mechanical engineering and car manufacturing have been hit hardest by the global recession, the steel industry is facing its worst demand downturn since the oil crisis of 1974-1975, Unctad says. Iron ore is of course affected.
Derivatives’ appeal grows
Yet some believe that the breakdown of this year’s iron ore price negotiations has been a blessing, as more participants have moved towards trading in the spot market.
“People that have been staunch believers in the benchmark are now at a point where they, too, recognise and publicly say that if the market moves more to financial indices when pricing the instrument, they will move in that direction,” says Key at Deutsche Bank. “They’re now aware that this is required.”
Hunt says the series of defaults last year made financial trading “much more acceptable and much more exciting and interesting”.
Market participants discovered, he says, that with swaps in place they could balance their physical risk against financial risk by taking opposite financial and physical positions.
“Secondly, if your counterparty was actually a proper company backed by a big bank rather than a dodgy trader with a laptop in Hong Kong that walks away from it, then that would also be much better,” he says.
For Ridge at Icap, it is still early days for the iron ore derivatives market. But he believes the industry has come a long way in a fairly short time: “It has leveraged lessons learnt from the likes of the evolution of the coal market, which took a significantly longer time to embrace the likes of clearing.”
The iron ore industry may be turning towards derivatives, and the potential is clearly enormous in terms of volume. But the market faces some hurdles. For it to be liquid, the physical industry, as a whole, needs to embrace it.
“The appetite for these things is coming more from the financial sector than it is from the physical market at the moment,” says Baker, though he says some of the larger trading houses are now starting to offer swaps that can be physically settled.
“You can’t just have the financial market, which isn’t embodied or embraced by the industry,” Key says.
Chinese engagement is certainly a precondition for success. Key says the next step is for the China Iron and Steel Association (CISA) to back down from its publicly negative stands on iron ore derivatives, which in turn will give many Chinese steel mills more flexibility to get involved in the market. “That will be the next wave of liquidity that will hit the market,” he says. “At the moment, they have to put up with this volatility and they need alternatives.”
Hunt’s diagnosis is that Chinese steel mills are quite keen on having more flexibility, but that CISA is quite cool towards the market, because it is scared of losing control.
Others prescribe patience. “It’s a bit like chicken and egg. If the liquidity picks up then we’ll get more people in and the liquidity will build. All the building blocks are in place. It just needs a bit of time,” Burden says.
It must be said, however, that the industry has been reluctant so far. Steel makers and miners can be suspicious of derivatives and very hesitant to enter the market. “Culturally, it’s a very traditional sort of industry. While we see it as a simple jump into derivatives, it might be more of waiting in on the part of the market participants,” Leppold says.
Some sources say BHP Billiton is the biggest of the miners pushing for derivatives, together with some smaller Australian miners. However, the company was unavailable to comment.
FOW also approached Vale and Rio Tinto for comment. A spokesperson for Vale in Rio de Janeiro declined to comment on derivatives while a spokesperson for Rio Tinto in Perth said in an email: “All our trades are supported by a physical position, and deliverable, so we have no need for derivatives or similar OTC arrangements.”
A spokesperson for Corus, part of Tata Steel Group, in London did not want to comment on derivatives but said the company was using the benchmark system. The World Steel Association, a major industry association, declined to comment on behalf of the industry on the grounds of “antitrust guidelines”.
CRU’s Baker says: “They’re [the industry] a bit worried that somehow it’s all financial alchemy and at the end of the day they’re not going to do well out of it, they’re somehow going to get their fingers burnt.”
Some steel mills have also voiced concerns about whether derivatives would really be beneficial for them. “People will point to the case with the London Metal Exchange and nickel, aluminium, etc, where you can argue that speculators were able to force prices up,” says Khayyam Jahangir, senior economist at London-based Roskill Information Services, which specialises in international metals and minerals markets.
Hunt says that this attitude is beginning to change. “The main driver is on the supply side to begin with, but the steel mills are also starting to recognise that this is a potential opportunity for them. The steel mills have always, over the years, been able to play the spot market against the benchmark price, so they like to have that flexibility a little bit. And they will continue to look at ways of reducing that cost. It’s more of a cost issue than a risk issue, whereas on the supply side the big mines are quite interested in managing their risk.”
A certain amount of interest is also coming from companies downstream such as car manufacturers, which have not really been able to use steel futures, Hunt says (see box on page 26).
Cheerleading for derivatives
The financial industry is adamant that derivatives markets do not cause volatility – rather, that they can only be a good thing. “The concerns about increasing volatility are unfounded. That is driven by physical supply and demand,” says Randall at The Steel Index. “The index is discovered purely from physical transactions.”
Hunt says: “If you look at what the market is, it’s already all over the place. We’re going up and down. It’s never flat. The market at the moment is extremely physically based. There is a huge physical market and a very small financial market – a long way from getting to the point when the financial market drives the price of the physical market.”
Randall says the annual benchmark process was designed to bring some predictability to pricing, so that companies could plan. “It could do that, but it could never do that for more than a year out,” he says.
A developed derivatives market could facilitate project financing by banks, helping them predict long term returns.
“If they know they can secure some revenue by selling futures five years forward, then obviously that greatly helps for the economics of financing projects. That’s where the steel industry and the steel supply chain has been so disadvantaged compared to every other commodity,” Randall claims.
Randall expects companies to start adopting a sort of “portfolio approach”. “We may see them increasingly just buying 10% or 20% of their iron ore on a floating price basis, and then testing the derivatives market a bit to hedge that, while they continue to buy the other 80% on more of a fixed price basis; and they’ll see what works for them.”
Waiting for the futures
It might be a long time until exchange-traded iron products appear. Once the OTC market becomes liquid and mature, then iron ore derivatives could migrate on to an exchange.
“There has been interest in an iron ore futures contract,” says Chris Evans, new products manager at the London Metal Exchange. “We look at many markets and assess the potential for bringing them on to the LME. But at the moment there are not plans for the LME to launch iron ore futures contracts.”
It is quite likely that exchanges will sooner follow SGX’s footsteps and start offering clearing facilities rather than listing fully fledged iron ore futures. Other exchanges may opt to team up with index providers. Some have been talking to them, several sources said.
Hunt confirms that Metal Bulletin has been talking to various exchanges about clearing swaps linked to the Metal Bulletin Iron Ore Index.
A spokesperson for Intercontinental Exchange in Atlanta declined to comment, as did a representative of CME Group, which offers ClearPort, a successful OTC clearing service.
Good things come…
Nevertheless, market participants maintain that there is a lot of client interest in the market. They have different views as to how and when the market will take off and how fast it will grow, but they generally agree that it could be big. “It’s got potential to be bigger than the coal swaps market, because the underlying market is a lot bigger,” says Burden.
The financial iron ore market could “easily” be a billion tonnes within five to 10 years, Hunt says.
“It’s one of those things that in time will attract more interest and will become a feature of the market, but I don’t think it’s going to be something that this time next year everybody is involved in, and it’s completely changed the face of the iron ore market,” says Baker. “It will be a creeping development over time.”