London, 19 October 2011: Reuters

The current slide in the spot iron ore price is set to trigger another step-change in how the steel industry prices its key metallic input. The widening gap between the spot price, now at 11-month lows, and the price charged by miners for Q4 deliveries has laid bare the problems with the quarterly price mechanism that replaced the annual benchmark system over the course of 2009 and 2010.

The most likely outcome will be an acceleration towards spot pricing, good news for the nascent iron ore derivatives market but highly problematic for steel mills that are still struggling to make sense of the shift from annual to quarterly pricing.

MINDING THE GAP

The problem with the quarterly pricing system as practiced by two of the big three global iron ore producers, Vale and Rio Tinto , is its lagging nature. Prices for each quarter are based on the average of the spot price, most commonly basis Platts' 62-percent iron content index , over a three-month period starting four months before the relevant quarter.

That works fine with steel mills when spot prices are stable or rising but not when they are falling. As of Monday, for example, the Platts spot price assessment was $152.25 per tonne. The quarterly price based on the same index with the four-month lag is around $175 per tonne.

Steel mills, particularly those in China, the largest collective buyer of seaborne iron ore, are not happy. They are, not entirely surprisingly, looking for greater flexibility from iron ore suppliers, particularly Vale, to take account of the widening gulf between spot and quarterly prices.

SAME PLAYERS, SAME PROBLEM

This is a re-run of the drama that caused the original collapse of the annual benchmark system. The cataclysmic slump in iron ore demand in late 2008 and the early part of 2009 saw the wholesale breaking of annual contracts, particularly by price-sensitive Chinese buyers.

That forced Vale, the most conservative of the "big three" iron ore miners, to switch to quarterly pricing, following a path already being blazed by revolutionary pace-setter BHP Billiton . Today, so far at least, there is no wholesale cancellation of contracted tonnages. Nor, so far at least, is there any reason to believe that steel production, and therefore iron ore demand, is poised to fall off the edge of a cliff.

Chinese iron ore imports were still running strong in September, up 15 percent on September 2010. Cumulative imports in the first nine months of this year were up 11 percent. China's own production of iron ore hit a record high of 1,551 million tonnes annualised in September. That's significant for prices given that the country's iron ore production at the margin is both low-quality and high-cost, in effect placing a cost-curve floor underneath prices.

But Chinese steel mills are experiencing severe margin compression and the combination of weakening domestic demand and heightened macro uncertainty has cast a lengthening shadow over the short-term outlook. Which is why they are looking for changes to the quarterly pricing mechanism to bridge the gap with sliding spot market prices.

Just as the annual benchmark system couldn't respond to the dramatic shifts in buying patterns that took place during the Great Contraction, so too has the quarterly pricing system been found lacking in flexibility.

Vale, which has previously said it was comfortable with its quarterly pricing mechanism, seems to be bowing to buyer pressure. Chinese steel mill sources have told Reuters that the company is offering to price Q4 deliveries against OctoberDecember spot rates, in effect removing the historic time lag.

Vale itself is maintaining official silence on the issue but if it does shift its quotational period, it will be following, again, in the foot-steps of BHP Billiton. Marcus Randolph, head of that company's ferrous and coal business, told reporters during the recent annual World Steel Association conference that BHP is now selling the "overwhelming majority" of its iron ore using monthly, rather than quarterly, reference prices.

Indeed, it is actively promoting an iron ore trading platform, along the lines of the Global Coal system, as a way of moving iron ore pricing even closer to spot prices. It is clear that the iron ore pricing revolution is still evolving. Quarterly pricing of the sort espoused by Vale, and to some degree by Rio Tinto, always looked no more than a staging post between annual and spot pricing mechanisms. It was a sop to a steel industry that was enraged by the price volatility that followed the demise of the old benchmark system, even if many steel mills were themselves instrumental in causing the revolution in the first place.

The annual benchmark is now dead and buried. Even the China Iron and Steel Association (CISA), which went into a period of public denial that annual pricing had gone for good, has now just launched its own spot iron ore index. Quarterly pricing may be poised to go the same way since it too risks disconnect with the shorter-period pricing that is gaining ever-increasing traction.

THE "VIRTUAL" STEEL MILL

If so, it will pose a further challenge to steel mills in terms of how they manage price volatility in their raw material inputs. Remember that what is happening in iron ore is being mirrored in the coking coal market.

After decades of static annual pricing, mills will now have to cope with prices that are changing daily. The template for how to manage such price volatility is already there in the way that the base metals sector hedges its price exposure via futures and options, mostly those traded on the London Metal Exchange ( LME). The problem for the ferrous sector is the profusion of possible products, ranging from iron ore swaps ( Singapore Exchange) and iron ore futures ( Singapore Mercantile Exchange) through hot rolled coil futures ( CME) to the LME's own steel billet contract.

Lack of standardisation remains the key constraint on industry participation but the building blocks are there for what is being talked about in trading circles as the holy grail for the steel sector. The "virtual steel mill" would allow price hedging against both inputs such as iron ore and coking coal and outputs such as hot rolled coil and billet.

It's still a collective ambition rather than a reality, although CME in particular seems to be close in terms of constructing a suite of possible contracts. But if Vale switches its quarterly pricing formula, the "virtual" mill will come one step closer.

Ends --

By Andy Home, Reuters market analyst – for Commodities Now with permission.

The views expressed here are his own.