November 2013


The iron ore pricing roller coaster

By Phillip Crowson

Over the last decade, iron ore miners have ramped up capacity to fill increasing steel production needs in Asia. During this time, they have benefited from higher iron ore prices due to both demand shortages and a more recent move to spot-related iron ore pricing. Having now addressed the global demand gap though, miners may soon see some negotiating power return to steel producers.

In 2011, the world’s 10 largest non-fuel mineral mines – and 16 of the top 20 – produced iron ore, accounting for 16.4 per cent of the mining industry’s total sales, according to the latest available figures from the Raw Materials Group. Ten years earlier, however, there were only eight iron ore mines in the top 20, collectively supplying 3.8 per cent of that year’s value of sales.

This marked rise in the iron ore producers’ share of the mining industry’s turnover was in part a natural consequence of the surge in Chinese steel production and demand for iron ore. Global output of iron ore more than doubled over the decade (from 934 Mt to 1,898 Mt). Many other commodities saw far more sedate rises during this period.

Overall, rising volumes were accompanied by sharp price increases. In 2011, copper and gold prices were 5.6 times and 5.8 times higher, respectively, than in 2001, but the price of internationally traded iron ore was 12.9 times as high as in 2001. Iron ore producers can legitimately claim that prices had been depressed for many years prior to 2001, and had been falling in real terms, during a period when demand was stagnant or rising very slowly. Once demand started increasing more rapidly, and existing capacity became inadequate, producers needed – and received – substantially higher prices to encourage investment in additional capacity, both at existing mines and at greenfield sites.

Up to the financial crisis in 2008, steel and iron ore prices kept broadly in step. Since then, they have followed different paths. Steel prices have fallen back from their 2008 peak. The London Metal Exchange’s cash settlement price for steel billet, admittedly only a rough guide to steel prices, has this year averaged only one third of its level reported in the second half of 2008. Iron ore prices, while volatile, remain substantially higher. Spot iron ore prices peaked in early 2011, some three times above their 2008 average. Today, iron ore prices are roughly 20 per cent below their 2011 peak, but that is still more than double their 2008 average.

Prior to 2008, prices for internationally traded iron ore were negotiated bilaterally between leading shippers and steel mills. Once one contract for the following year’s price had been agreed upon, other contracts were quickly settled on roughly similar terms. With the rapid rise in Chinese demand and a growing spread between contractual prices and spot delivery prices, iron ore producers seized the opportunity of the sellers’ market to move to spot-related pricing. This boosted their short-term profits, improving shareholders fortunes and no doubt management bonuses. Today, most sales are at prices closely linked to prevailing spot quotations.

In the tight iron ore market conditions of 2008, steel mills were powerless to resist the move to spot-related pricing, however much they disliked it. Yet apart from minor uses, iron ore’s only market is in steel production. The longer-term health of the suppliers is inextricably linked with that of the steel industry. Will the balance of power remain in the iron ore suppliers’ favour while its customer industry remains weak? Since the benchmark system collapsed, spot prices have probably been much higher than those that would have been bilaterally negotiated. That does not mean that they always will be, although a return to the old pricing system is unlikely.

The rise in iron ore prices has not only greatly boosted the profits of the major shippers but it has also encouraged new entrants and a strong continuing increase in productive capacity. Once new capacity has been installed, the prices needed to keep that capacity operating are much lower than the prices needed to tempt in new production.

Looking ahead, the majors should continue to earn reasonable­-to-good profits, even with much lower prices. Some of the newer entrants may be squeezed but they are unlikely to close down – or at least not unless prices fall very low for an extended period. New capacity will be delayed, but then the dynamic of so-called cost reduction may take over, as companies expand to spread fixed costs so that unit costs go down and profits go up. One seductive danger is that the low-cost producers will continue producing flat out in the expectation of making profits, no matter what happens to total demand. The trouble is that such a view often prolongs the agony of weak markets for all concerned.

Phillip_CrowsonPhillip Crowson is a former chief economist of Rio Tinto, chairman of the European Copper Institute and president of the Mining Association of the United Kingdom. He has written several books and published many papers and articles on aspects of the minerals industry.

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