IronOreARapidlyMaturingMarket

March2011
Over the past decades, we have witnessed the commoditisationofanumberofmarketsincludinggold, base metals, more latterly coal and steel and now iron ore is being dealt a similar treatment. Iron ore prices were historically set via a bilateral process of annual contract negotiation, as has been widely reported. This pricing mechanism is no longer being used by major market participants and the spot iron ore price has consequently become increasingly significant for trade. This change in pricing mechanism has led to the progressivedevelopmentoffuturescontracts,aforward market and OTC hedge contracts. The development of the iron ore market has quickly gained considerable traction evidenced by the growing volume of futures contractstraded. This paper outlines the market forces currently driving prices and discusses the hedging alternatives becoming increasinglyavailable. Market outlook The robust performance of iron ore is forecast by most analyststocontinuethroughoutcalendaryears2011and 2012 driven by supply constraints and a better global economicpicturesupportingdemand. Supply factors A prime factor on the supply side revolves around the uncertainfutureoftheIndianexportmarket.Itiswidely anticipated that a much greater proportion of Indian production will be diverted to its own domestic steel industry.Asthethirdlargestproducerofironore,thisis material exports are over 100mt and mainly to China. TheIndianMinistryofSteelsupportsacompletebanof ironoreexportsandanexportbanonprivatecompanies has been in place since July last year in the state of Karnatakatoreduceillegalmining(thisiscurrentlybeing appealedintheSupremeCourt).InadditiontoOrissa,a further Indian state, Chhattisgarh, is also seeking a ban onexportsfortheirstaterunminer(Federalgovernment approval is required). Further, on Feb 28 the Indian Federal government announced a hefty hike in export dutiesassociatedwithironoreameasuredesignedto curbexportsandpromotelocalsteelmaking.Themarket isexpectinghigherpricesasaconsequencealthoughthis hasyettoeventuate. Broader supply side issues at play include the ongoing decline in the quality of Chinese iron ore production thoughttobe onlyprofitableatpricesoverUS$120/mt. Braziliansupplyhasfailedtogrowandisfarfromkeeping pace with the growth of Australian production, This is attributed to weaker exports into Europe and broader domesticinfrastructureissues.Themediumtermoutlook from 201314 should start to see a resumption of Brazilianproductiongrowth,whichwhencombinedwith theforecastAustralianproductionlevelsgoesalongway toexplainingthelongertermlowerpriceexpectations. Demand considerations On the demand side, while the global economy is on a much more stable footing, the outlook for iron ore and steel is consideredsomewhat softer. Steelproduction is expected to pullback this year, with last years Western restockingactivitylargelyremovedfromthemarket.This iscombinedwithaChinesedeterminationtomeettheir own energy efficiency targets (recall last years power cuts to industry), together with a broader consolidation of their steel industry. The supply constraints however are forecast to outweigh any softness in demand, to broadlymaintainpricesatcurrentlevels. Risks to the forecast outcomes Mainriskstothisoutlookcurrentlyincludetheimpactof emergingmarketinflationarypressures,anyconsequent tightening of monetary conditions and Middle East tensionsdrivingaprolongedescalationofenergyprices, puttingthefragilewesternrecoveriesatrisk.Thecurrent level of backwardation (where forward prices are lower thanspotprice)istestamenttotheserisks. Contract pricing As the iron ore market has moved away from annual contractpricing,increasingvolumehasbeendivertedto thespotmarket.Theintroductionofanironorefutures contract by the Singapore Exchange (SGX) in April 2009 has served to provide transparency in spot and forward pricingforthemarket.Thecontract,basedonaTSI62% Iron Ore product landed in China, has seen increasing volume traded since inception, culminating in a record monthinJan2011ofover4,000lots(approx2.2million tonnes,seechartbelow).

IronOreARapidlyMaturingMarket
TSI Spot and Forward Curves

Price per Tonne (USD)

New hedging tools Some smaller Indian exchanges (MCX and ICEX) have alsorecentlystartedfuturescontractsonIndianbased products however the SGX product remains the currentbenchmark.
SGX Trading Volume vs TSI Spot Prices
5000 4500 4000 $170 3500 Price per Tonne (USD) 3000 2500 2000 1500 $90 1000 500 0
4/ 20 09 31 /0 5/ 20 09 30 /0 6/ 20 09 31 /0 7/ 20 09 31 /0 8/ 20 09 30 /0 9/ 20 09 31 /1 0/ 20 09 30 /1 1/ 20 09 31 /1 2/ 20 09 31 /0 1/ 20 10 28 /0 2/ 20 10 31 /0 3/ 20 10 30 /0 4/ 20 10 31 /0 5/ 20 10 30 /0 6/ 20 10 31 /0 7/ 20 10 31 /0 8/ 20 10 30 /0 9/ 20 10 31 /1 0/ 20 10 30 /1 1/ 20 10 31 /1 2/ 20 10 31 /0 1/ 20 11

$200

$185

$170

$155

$140

$125

$110

$95

$210
$80

$190
$65

$50 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Spot Jul-10 30-Jun-10 Oct-10 30-Nov-10 Jan-11 Apr-11 Jul-11 31-Jan-11 Oct-11 15-Feb-11 Jan-12 Apr-12 Jul-12 Oct-12

$150

31-Dec-10

Lots Traded

$130

Chart2:HistoricalTSIpricesandForwardCurves

$110

$70

$50

Monthly Volume (lots) Cleared SGX

TSI Iron Ore Pice

Chart1.TradingvolumeinIronoreontheSGX

In response to the shift from annual contracts, banks havebeguntoofferhedgeproductsenablingcustomers toreducetheirnewexposurestofluctuationsinthespot market. Primarily, the product offering has consisted of ironoreoverthecounterswaps,offeredbyincreasingly more bank counterparts. And although not as common, with the development of a more mature market and to meet expected demand, major participants such as Credit Suisse, Deutsche and Citibank are now offering optionproducts. SGX Futures Settlement prices as at 1 March are as follows: Mar11:174.00 Apr11: 163.17 May11:161.08 Jun11: 159.67 Q211:161.31 Q311: 154.39 Q411:150.22 Q112: 146.47 Q212:143.86 Q312: 141.33 Cal12:142.75 Cal13: 131.04 Todate,thetakeupofhedgeproductsbyproducershas beenslow.Thebackwardationoftheforwardpricecurve has acted as a considerable disincentive in a bullish market, as has the immaturity of the market. However, we do expect this to change and to see the use of hedginginstrumentsriseoverthenotdistantfuture. Calendaryear2012iscurrentlytradingabove140USD/T (or133USD/TFOB),notunattractivelevelsgivenrecent historybutsomedistancefromspotatUS$180/T.

Oakvale response With the ongoing development of the iron ore market, wehavesoughttoanticipateourclientsneedsandhave addedIronOreSwapstoourproductlisting.Clientscan now receive MarktoMarket reports and hedge accounting assistance on contracts based on China landed 62% fine prices provided by The Steel Index, Metal Bulletin, Platts or any combination thereof, denominatedinUSDorAUD. Inadditiontothis,valuationsforfreightswapstakenout ontheBalticC5freightroutearealsoavailableforthose wishing to cover an FOB exposure. Implementation of bothoptionproductsandsensitivityanalysiscapabilities willfollowinphasetwo. Please feel free to call any of the Oakvale Team listed belowtodiscussanyofyourcurrentorfutureneeds. (08)94605305 Perth JohnDaljac DivisionalDirector NathanWoodrow SeniorAssociate (02)88236200 Sydney PaulTravers ExecutiveDirector ElizabethBlackhurst AssociateDirector
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