ANALYSIS-Real winners of iron ore talks? Banks, not miners

Published: 06 Jul 2009 00:23:37 PST

* Banks, exchanges, brokers offer ore derivatives

* Progress seen slow, as Asian customers remain reluctant

* China holds key for the success of alternative mechanism

LONDON/SEOUL, July 6 - China's move to pay spot prices for iron ore rather than accept a benchmark agreed with other countries could support a push by investment banks for wider acceptance of new pricing methods.

Although a complete take-off may take years, banks, exchanges and brokers will speed the process of introducing new pricing tools for iron ore, hoping to generate fat revenues by broking and making markets for for derivatives, analysts say.

"It's no doubt that the market's going forward. There are participants who use it as an insurance policy. We see producers, traders, freight people coming to the market," said Ray Key, global head of metals trading at Deutsche Bank, referring to the iron ore derivatives market.

China, frustrated by its failure to win a deeper iron ore price cut by a negotiations deadline of June 30, is now signalling readiness to price sales on a quarterly or twice-yearly basis, opening the door for a wider use of iron ore derivatives by mills and traders.

Mining giant Rio Tinto said on Monday Chinese buyers were choosing to pay spot prices for iron rather than agreeing to the benchmark price settled with other Asian steelmakers.

With spot prices gyrating and no immediate signs of an end to the deadlock, analysts are starting to see a more urgent need for new pricing hedging tools.

Spot iron ore prices hit record highs near $200 a tonne last year, only to fall to a four-year low of around $60 in April, but have since recovered, encouraging mills, especially spot market focused Chinese units, to seek alternative steps to manage growing price risks.

With trading volumes at a massive 800 million tonnes a year globally, iron ore remains one of the biggest non-exchange traded bulk commodities, luring the financial community eager to tap a new source of revenue.

And given that derivatives trading in other established commodities markets such as coal and oil far exceed physical trade volumes, the stakes are high.

Morgan Stanley has also begun trading swap iron ore contracts, while Goldman Sachs and Barclays have said they are considering entering into the market.

Credit Suisse and Deutsche Bank are among the early entrants: They launched over-the-counter paper market for iron ore in May 2008. Trading volume has been small, at 10 million tonnes, although those banks see it doubling this year as the benchmark pricing system is set to break down.

The Singapore Exchange also joined the move, launching the world's first OTC iron ore swaps for clearing in April, and has settled contracts worth over $23 million so far.

CHINA HOLDS THE KEY

OTC iron ore swap contracts, which are settled against published indices based on spot physical ore, have gained some popularity alongside the spot iron ore market.

Still, with several European and Asian mills appreciating the benchmark's stability in their annual cost planning, these new tools are not likely to gain traction overnight.

"There's no sign of consumers using these mechanisms, just not yet," said Jim Lennon, analyst at Macquarie Bank. "The liquidity is very low and it could take up to 2-3 years, it's not going to take over just like that."

A real take-off of these new tools may need state backing from Chinese government, which has a track record of limiting corporate derivatives trading to manage its investment risks.

In the latest evidence suggesting China wants direct control of iron ore trade, the state-backed CISA has reportedly told the country's first iron ore trade platform that it cannot deal in imported ore.[ID:nSHA317394]

"There are quite a lot of Chinese mills interested, but CISA is saying they should not be a part of it, so the mills don't want to be seen active," Key at Deutsche Bank said.

Three indices are now used as benchmark prices for iron ore derivatives deals but all have have yet to gain wide acceptance from miners, steelmills and traders.

"The swaps market is still developing so it is not clear who is using what always for settlement contracts. It mainly depends on customer preference," said Cameron Hunt, Metal Bulletin iron ore index director.

Chinese mills, the world's biggest iron ore buyers and also the biggest steel consumers, also remain cautious about these new products.

"We have no immediate plan to use derivatives as we prefer the benchmark pricing system," a senior official at a leading Asian mill said.

"Also none of the iron ore indices available at the moment is accurate and fully reflects spot market prices. It needs more time to be accepted by the market participants."

Resource-hungry China also seems to have second thoughts about their effectiveness and wants to lead the development, which some traders warn could stymie progress as it raises risks of government meddling and price manipulation.

"I don't think many Chinese firms will use iron ore derivatives as all the three indexes are managed by the foreign companies and the Chinese government is worried about the longer-term pricing power," said a senior executive from Sinosteel, a leading state-owned trading firm.

"We are the world's largest producer and consumer (of steel), so I think after the Shanghai steel futures we can have more related futures contracts of our own in the country."

For a factbox on iron ore indices, click on [ID:SIN377598]

For a factbox on new iron ore pricing tools, click on [ID:nSP361332]