Report on iron ore derivatives market growth

1. METALSwww.platts.com/metals
MARCH 2016
Oscar Tarneberg, Senior Analyst
2016:SIZEOFIRONORE“PAPER”TRADE
TOSURPASSPHYSICAL

2. SPECIAL REPORT: METALS 2016: SIZE OF IRON ORE “PAPER” TRADE TO SURPASS PHYSICAL
2Copyright © 2016 by Platts, McGraw Hill Financial
This year is likely to mark the first time that more “paper” tons
of iron ore will be traded than the real red stuff. Yet the rise of
derivatives trade has to date gone relatively unnoticed, and has
broadly happened without a large degree of participation from
major iron ore mining companies. However, thinner margins
resulting from lower prices and cut-throat competition will
mean these price risk management tools become increasingly
important for all participants. Those who use them will thrive
as the market is moving from a boom period to more austere,
and even treacherous, times. Growing liquidity and usage in this
market will make hedging easier for all in the value chain .
In 2008 a number of investment banks and broking shops
strove to create financial markets in iron ore akin to those seen
in other commodities, most notably in oil. They took the view
that rising volatility stemming from China’s economic rise would
necessitate hedging instruments to manage forward price risk
for iron ore. Oil refiners and airlines were already using futures
to lock in their input prices in advance. Therefore, the reasoning
went, iron ore miners would want to do likewise, given their
expensive expansion projects and long lead times. Steel mills
filling their order books for the coming year would surely benefit
from visibility on their future input costs.
These first derivatives contracts were something of a niche
experiment, drawn up “over-the-counter” (OTC) by banks, and
settled against an assortment of available prices for imports of
63.5/63% Fe Indian iron ore into China. The move towards an
exchange-cleared, standardized market came with the launch
by Singapore Exchange (SGX) of an iron ore swap contract
cash-settled against the then recently-launched The Steel Index
(TSI) reference price for 62% Fe iron ore fines delivered into
China. Other exchanges followed, including CME Group and LCH.
Clearnet, among others.
PAPERMARKETLIQUIDITYDEEPENS
The wholesale shift away from annually negotiated iron ore
supply contracts to index-based pricing in 2010 gave serious
momentum to the embryonic swaps market, as widespread
use of indices made it easier to lock in forward prices by taking
opposing positions in the paper and physical markets against an
index. But liquidity was initially a bottleneck for those looking to
hedge serious tonnages. If a mill wanted to hedge a year’s worth
of iron ore procurement, for example, they would need someone
to take the other side of that deal. Executing a position of that
size in a thinly-traded market could have an outsized impact on
market values, even if the depth in tons was there to start with.
Liquid markets also provide investors with confidence, as this
lessens the risk of them being stuck with a losing position that
is hard to exit quickly.
Since 2009 traded volumes have more than doubled annually
year-on-year, averaging a growth rate of more than 130% per
annum, such that in 2015 more than 1.1 billion metric tons of iron
ore derivatives were cleared. But it was only in the latter part
of last year that the volume of derivatives surpassed tonnages
traded physically. In the coming year, this trend will continue
and paper volumes will eclipse the size of the entire seaborne
market. In January alone, more than 150 million mt of swaps,
options and futures were traded.
While this still leaves iron ore a long way behind many other
commodities with more mature derivatives markets, such as oil
– which has a financial market ten times larger than the physical
one – it still represents a key milestone in the commoditization
of iron ore.
MINERSWARMTODERIVATIVES…SLOWLY
The most active participants in these new derivatives
markets for iron ore have so far been traders and banks, with
increasing levels of participation from Chinese mills. For the
most part, miners have stayed clear of “paper” iron ore and
focused on mining the real thing. In an industry which was, for
the best part of 30 years, operating on annual prices barely
moving from year to year, forward price visibility was – until
recently – not much of an issue. Expertise in iron ore mining
thus focused mainly on logistics and engineering. Financial
instruments, such as swaps and options, were generally
viewed as something that banks and speculators dealt with,
not mining companies.
To be fair, there was little appetite, nor any pressing need,
for the miners to jump into derivatives. Despite China’s rise,
both economically and in steel production terms, which
ushered in an era of increasing price volatility for iron ore, the
past decade was one in which prices seemed to eventually
go higher rather than lower. Surging demand proved hard to
satisfy in an industry where new developments take many
years to bring online.
Anyone selling iron ore was therefore understandably loathe
to lock in forward prices below current spot price levels, which
is what would have happened had they tried (see example
in chart). If experience showed that prices would generally
trend higher, why hedge at a lower price? Certainly no one
would thank you for doing so. An oft-heard refrain from iron
ore producers when asked about their aversion to price risk
management tools, was that their shareholders were looking for
exposure to the iron ore price. So why give away that upside for
the sake of lower, but stable, prices?
IRONOREFORWARDCURVES: LOCKINGIN FUTURE PRICES
Source: SGX, TSI
($/dmt CFR)
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
0
50
100
150
200
Spot price
Jun-09
30-Jul-10
30-Jun-11
12-Sep-12
16-Jan-14
29-Oct-14
12-Feb-16

3. SPECIAL REPORT: METALS 2016: SIZE OF IRON ORE “PAPER” TRADE TO SURPASS PHYSICAL
3Copyright © 2016 by Platts, McGraw Hill Financial
For more information, please visit us online or speak to one of our sales specialists:
www.thesteelindex.com
support@platts.com
NORTH AMERICA
+1-800-PLATTS8 (toll-free)
+1-212-904-3070 (direct)
EMEA
+44-(0)20-7176-6111
LATIN AMERICA
+55-11-3371-5755
ASIA-PACIFIC
+65-6530-6430
RUSSIA
+7-495-783-4141
© 2016 Platts, McGraw Hill Financial. All rights reserved.
DERIVATIVES’APPEALRISESINRISKIERTIMES
Shareholders typically do not want to be exposed to a price
which is falling hard. Chinese steel production growth began
slowing about five years ago, and eventually contracted in 2015,
just as a raft of new iron ore expansion projects reached fruition.
The ensuing reversal in the supply-demand balance began to
bite into prices in 2013. By 2014, it appeared the real speculators
were the miners which had invested heavily in capacity
expansions in anticipation of ever-growing Chinese demand.
A recent research note from SGX analysts suggested the
response to the downturn from most miners has been to strip
out costs in a “race to the bottom”, at the expense of dividends
and equity valuations. In contrast to the iron ore industry, where
valuations have fallen faster than physical prices, they pointed
out, shares in oil firms (where hedging is the norm) have actually
outperformed the spot price.
While larger miners have benefited from economies of scale and
their access to first-class assets to remain profitable – making
reasonable margins even when prices crashed below $40/dry
metric ton CFR China – they may have been higher with hedging
programs in place. The biggest victims of the recent price
plunge have been smaller, higher-cost miners. Many of these
were incentivized to develop projects (most never even entered
production) by what may turn out to be a brief historic period of
very high prices. In response, some have subsequently embraced
price risk management tools, but this has broadly been triggered
as a defensive measure in ‘life-or-death’ situations rather than
adopted early as a proactive policy or as a condition of financing.
Last year, Perth-headquartered Atlas Iron was forced to halt
production amid the precipitous plunge in prices which made
continuation of its mining operations in the Pilbara unviable.
But through a combination of rearranging agreements with
contractors, aggressive cost-cutting and forward hedging of
iron ore prices using swaps and options, the company was able
to restart operations after a relatively short stoppage. More
recently, other smaller players have been implementing price
risk strategies, while rumors suggest larger miners may be
doing more hedging via banks.
Looking forward – particularly to the more straightened times
ahead – the deeper liquidity in financial markets for iron ore,
as well as a broader range of price risk management tools now
available (including futures for lump premiums and lower-grade
ores), will make hedging easier, as well as essential practice.
Sellers will be able to take advantage of periods of higher prices
to secure better sales prices further out into the year, while
buyers will be able to do the same for their purchase prices in
periods of depressed prices. Increasingly too, banks will request
hedging structures as a condition of loans for any new mining
projects, and possibly when extending credit lines. Those that
are best able to utilise these new tools will be the ones who will
survive and thrive.
IRONOREFUTURESANDOTCDERIVATIVESCONTRACTS
VOLUMESCLEARED*
Source: TSI
*SGX, CME Group, LCH.Clearnet, NASDAQ OMX Clearing and ICE
(million mt)
0
40
80
120
160
DecNovOctSepAugJulJunMayAprMarFebJan
2010
2009
2012
2011
2013
2015
2016
2014