Iron Ore: It’s About The Balance of Power

Traditionally, since the 1960’s Iron Ore contract prices have been agreed with major steel mills in Europe, Asia and North America through year long benchmark pricing. The orginal reasoning for this year long pricing structure was to guarantee longer term contracts, at a time when the demand for iron ore was relatively low, and Japanese steel mills were searching for reliable and consistent supply. At this time, the negotiating power was definitely in the hands of the steel mills. As a result, they could demand a year long fixed price that would generally be below the iron ore spot price on metals markets.

In the past thirty years the world has seen the greater emergence of large developing economies such as China, who have shown a ferocious appetite for iron ore and steel production. As the global economy grew, and the Chinese and broader Asian economies expanded rapidly, the demand for iron ore has equally grown to the extent where there is now a gulf of variation between the benchmark pricing system and the spot price of iron ore on metals markets. Why is this gulf of difference so important now?

The power dependence relationship between the buyers and the sellers has changed. Where once the power was fundamentally held by the steel mills, the growth of steel mills in China has seen the competition for iron ore develop faster than supply can be increased. This increase in demand has been so rapid that the power now rests with the iron ore suppliers: Vale, Rio Tinto and BHP Billiton. Of course this power dependence shift has seen an increase in tension in iron ore price negotiations, characterised last year by the protracted and then suspended negotiations between Rio Tinto and the Chinese iron and Steel Association. The issue at hand with these protracted negotiations is that both sides have been playing hard ball, and because the suppliers now hold the balance of power, they have been able to hold out the longest without too much ill effect on their businesses. The 2008 benchmark price was high, to accommodate for the huge demand that was seen around the world just before the global economy imploded. In recent months we have seen the spot price of iron ore equally high, so the alternative pricing arangements for the steel mills are to stick with the 2008 price, or go to a high spot price until a benchmark price is agreed. You could say that this is a perfect negotiation situation for the iron ore suppliers. Steel still needs to be made, whether or not a benchmark price is agreed or not.

This situation has now led to the recently announced move to short term pricing on iron ore contracts, by both Vale of Brazil, and BHP Billiton of Australia. Short term pricing will more closely reflect the spot price, and is likely to be set quarterly not yearly as with the benchmark system. A change like this has not been agreed by all steel mills at this stage, but while the spot price remains high, and demand for iron ore equally remains high, there will be little alternative for steel mills than to adopt this new system. Short term negotiations do have its advantages for both steel mills and iron ore suppliers. It allows for regular adjustments to meet new economic environments whether high or low demand. At the same time, more than likely maintaining a short term price below the spot price for iron ore, which preserves the cost advantage to major steel mills. The question that will be asked by steel mills is whether this short term pricing system will overly favour the iron ore suppliers during negotiations?

The balance of power has definitely shifted to the iron ore suppliers, but ultimately the answer to that question will only be known in the long term. More importantly, some of the heat may now come out of the traditionally complex and protracted iron ore price negotiations.

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