Is the Iron Ore Industry at a Tipping Point?

Although iron is one of the most abundant elements on earth, the market for iron ore is surprisingly complex. Securing iron ore, which is used to make both iron and steel, is a priority for many nations. While iron oxide deposits are fairly common, some geographies are more endowed with mineable resources than others. And even then, iron content among deposits varies, with some deposits containing higher-grade material than others. In 2007, total global iron ore production was about 1.9 billion tons. At 600 million tons, China was the largest producer. However, the country reports statistics in crude ore terms, as opposed to useable ore, which takes into account the iron content of the soil--the more iron, the higher the grade. When quality is taken into account, Brazil and Australia are considered the largest players, producing 360 and 320 million tons of useable ore in 2007, respectively. China has an abundance of ore, but the quantity it produces can't make up for the inherent lack of quality of domestically produced ore. As a result, it is the world's largest consumer of seaborne iron ore. In fact, it is estimated that China increased domestic ore production by 40% in 2006, yet imports of higher-grade ore increased by 15% in 2007.

The three largest iron ore miners-- BHP Billiton, Rio Tinto and Vale--together provide two thirds of the world's seaborne iron ore. Given that most countries don't have sufficient domestic supplies, the export market--primarily seaborne ore--takes on special importance. The oligopoly-like structure of this market has spawned a pricing dynamic that sets iron ore apart from other major commodities. Iron ore doesn't trade on commodities markets like other important inputs such as oil and copper, and there is no futures market. A spot market exists, where steel producers can purchase ore for immediate delivery, but most is sold on a contractual basis, with its price determined by a negotiated benchmark. Theoretically, by having the price set through a negotiating process, the best price for both parties is achieved. In general, iron ore producers and large steel mills are the first to settle price negotiations. Once the top-tier buyers and sellers have settled on pricing, the small to midtier steel mills and mining companies fall into line, nailing down their own agreements for the April to March contract year.

Tough Negotiating and Sky-High Prices
Iron ore contract negotiations have become increasingly contentious as world demand has soared over the past several years. The main driver behind the surge in demand has been rapid growth in China's steel production capacity. In the past five years, Chinese steel production has grown nearly 23% annually versus worldwide gains (excluding China) of about 3.5%. In 2007, China accounted for about 36% of total global steel production and was responsible for 64% of production growth for the year. Largely as a result of China's growing appetite for steel, world iron ore production grew from 1 billion tons in 2000 to nearly 1.9 billion tons in 2007. Despite this rapid ramp-up in capacity, global supply and demand balances remained whip tight, sending the price for iron ore fines up by 386% over the same time period. In fact, the 2008 contract year negotiations resulted in a record sixth consecutive price increase.

2008 Negotiations Set a New Standard
In 2008, we have seen a divergence from this annual benchmark system that will likely influence the 2009 negotiations. Brazilian mining giant Vale first agreed to a 65% year-over-year increase with Asian steel producers in February. Typically, other iron ore producers, such as BHP Billiton and Rio Tinto, have followed Vale's lead in the price negotiations. Yet, this year the Australian iron ore producers bucked the trend, pursuing an even greater increase. The Australians argued that because it's cheaper to ship iron ore from Australia to Asia as opposed to shipping from Brazil, their ore deserves a transport premium. Generally, steelmakers are stuck footing the bill for shipping ore. Asian steel producers reluctantly agreed, and the two companies were able to push through price increases in excess of 80%.

Since then, shipping costs have plummeted (see Morningstar Stock Analyst Adam Fleck's article on shipping here), and Vale is now asking for further increases from the Chinese producers. The Brazilian miner argues that because it no longer costs as much to ship its ore from Brazil to China, it is entitled to charge nearly the same rate as the Australian miners. Meanwhile, the Australian miners are threatening to break from the benchmark system by selling more iron ore on the spot market and have also hatched plans to construct hybrid contracts that include regular price adjustments based on spot prices. They cite the discrepancy between the iron ore spot market prices and contract prices as justification for moving away from the old system.

For the past several years, spot prices for immediate delivery have typically been higher than the benchmark price. Miners obviously want to sell their ore at the best possible price, and have therefore argued that they should be able to sell more ore into the spot market. Of course, as we have seen recently, the spot price can also dip below the benchmark price. One reason the Australians may want to continue selling ore on the spot market despite depressed prices is to drive those players with higher-cost operations out of business, further solidifying their oligopoly-like position. Vale, for its part, so far has remained a staunch supporter of the benchmark pricing system. But its insistence on being compensated for lower shipping rates in the form of an unprecedented midyear price increase illustrates the fragility of the benchmark framework. As the annual negotiations begin at the end of October, we suspect that some major changes could be in the works for the iron ore benchmark system.

Lower Prices Ahead
So what's in store for the next round of negotiations? Lower steel prices will be top of mind for both parties. The prices for many types of steel around the world have plummeted from recent highs. In response, many major steel producers are slashing output. For example, industry leader Arcelor Mittal is considering plans to cut global production by 10% to 15% in response to building inventory levels. Russian and Chinese steelmakers have announced reductions of their own. China’s biggest steelmaker, Baosteel, is reported to be cutting output by 10% this quarter.

With slowing steel production comes weaker demand for iron ore. Recently, Australian iron ore producer Mount Gibson acknowledged that some Chinese customers have asked to delay shipments. Spot prices of iron ore have also fallen below benchmark prices. It looks likely, then, that the steel producers will have the upper hand in the coming 2009 contract year benchmark negotiations, which we believe will result in lower iron ore prices. Adding to steel producers' bargaining power is the fact that the Australian dollar and Brazilian real have fallen swiftly relative to the U.S. dollar. Since iron ore contracts are priced in U.S. dollars, all three major ore producers should benefit from lower operating costs, given that they are primarily denominated in their local currencies. We think that steelmakers will be able to effectively argue that it now costs miners less to produce their ore, further undermining support for higher ore prices. With these factors in mind, we have projected a decrease in iron ore prices for 2009, and depending on the depth and the breadth of the current economic slowdown, we think another reduction may be in the cards for 2010. Overall, the next round of negotiations will be just as dramatic and exciting as the last, and we will be watching them closely.