Iron ore swaps may help price risk management

News was prepared under the information support of Online Daily Newspaper on Hellenic and international Shipping "Hellenic Shipping News".

31 Oct 2010

How does a steelmaker achieve raw materials security? Either by way of owning mines, not an easy proposition though because of competition becoming increasingly intense in acquiring deposits or by using swaps in the derivatives field to hedge price volatility and thereby manage risk. SAIL and Tata Steel group’s Indian operations have the benefit of total captive sourcing of iron ore and also partly for coking coal. But the other big steelmakers here like most of their peers abroad do not have this luxury.
TSG makes the major portion of the metal in Europe, the UK and south-east Asia because of its ownership of Corus and Natsteel. The group though has acquired interest in coal and ore properties in Mozambique and Canada to be developed remains vulnerable to what chairman Ratan Tata describes as “opportunistic price” setting by the world’s big three miners.
Whatever its plans for minerals assets acquisition, TSG will be required to buy very large quantities of iron ore and coal from the market destined to remain highly volatile. This explains why the group is to develop “operating and hedging strategies” to tackle the uncertainties of spot markets. Mind you not only did iron ore become twice more expensive at one point since last year, the dropping of the 40 year old benchmark system of annual contracts for quarterly pricing system linked to the spot market has created the ground for significant price swing.
The biggest mover of the ore market, as the world is seeing it again and again, is any news relating to China. This is because as the world’s largest producer of steel but with restricted domestic supply of the mineral on ideal iron content basis, China has huge dependence on imports, including from India.
Initially, it was said that China’s ore imports will rise seven per cent this year to 670 million tonnes. But now an official of China Iron & Steel Association (CISA) says imports in 2010 will likely fall. In this year’s first eight months China imported 405 million tonnes of ore and according to a projection by Dow Jones, the last four months will see imports of 56 million tonnes each month.
All this and also the unpredictability of China as to when it will destock or restock or ask the steel industry to cut production for saving energy move the ore market sharply. So also the fact that in spite of very low iron content in its ore, China has pushed average monthly ore production to 100 million tonnes. Experts say the majority of Chinese iron ore mines being underground and the mineral not of desired quality, their cost structure is “very high.” But reports from China are to the effect that braving all constraints, the country will continue to ramp up production of ore. Are not such contradictory reports good recipe for price fluctuations?
Chinese steelmakers used to buying good volumes of ore in the spot market are showing growing interest in swaps. But the privately-owned ones have started hedging their exposure to ore through swaps, but a little secretively routing the deals through Singapore exchange. It is, however, not that the state-owned companies are not interested in swaps.
What they cannot ignore at this point is the advice from CISA and China Chamber of Commerce for Metals and Minerals that they should not be “mired in swaps.” At the same time CISA has conveniently left a window open for swaps to be used in future.
Whatever that may be, two things will decide as to how fast ore swaps will grow. Swaps got the first leg up with the ushering in of the new ore price fixing regime and swelling of the spot market beyond fines to lump ore.
First, the agencies offering swaps will have to introduce products needed for large groups like ArcelorMittal, Bao and TSG to hedge ore exposure. Secondly, ore swaps market will grow exponentially once the Chinese authorities allow the mills to make use of the instrument for hedging risks. In less than a year, the volume of ore traded in the swap market jumped nearly 12.5 times to 2.5 million tonnes. From here, the swap market could grow even faster provided of course Chinese mills come and participate in the trade openly.
In a mineral where spot trading and not benchmark price system becomes the rule, it is only to be expected that more and more miners and user mills will make use of swaps liberally for price risk management. In a price uncertain market, swaps will allow miners to lock in given ore volumes and at prices they want while users get to hedge risk for their main raw material.
But where does this leave the middleman? He finds in swaps a way to hedge the price of an undisclosed volume of ore. Iron ore swaps were kicked off by Deutsche Bank and Credit Suisse in 2008 with Japanese mills as clients. Morgan Stanley has introduced its set of products since. Now wait for other heavyweights like Goldman Sachs and Citigroup to ride the ore swaps bandwagon.

Source: Business Standard