Commodities are adjusting to the reality that the peak years of the China-driven commodity super-cycle are over. With China producing half the world’s steel, no commodity is more exposed than iron ore to the deceleration in the world’s second-largest economy. Since the beginning of the year iron ore prices have already lost 50 percent.
Despite these steep falls, the outlook for iron ore remains hard to call, buffeted by weak demand in its biggest market and an uncertain future supply picture.
How supply adjusts to new lower prices is the key swing factor in most forecasts. An iron ore glut could see a surplus of over 300 million tons by 2018, according to analysts at Citi, sending prices in 2015 into the $50-a-ton range.
Despite this, industry giants such as BHP Billiton and Rio Tinto have reiterated commitments to aggressive capacity expansion, undeterred by the soft pricing environment. Other producers cannot afford to be so sanguine and a shakeout is expected across various higher-cost producers.
Meanwhile, such volatility has increased the desire for price certainty. This new rollercoaster in iron ore comes only six years after the industry ended the practice of annual price fixes to spot prices and short-term contracts. The upshot is more industry participants are looking to derivative contracts, often for the first time, to help manage risk.
To understand more about the changes facing the industry and how best to use metal-related derivatives, we sat down with Youngjin Chang, Senior Director ofMetals Products and Yvonne Zhang, Director of Metals Products for Asia, at CME Group to find out more.
Has recent price volatility in iron-ore accelerated the move towards more widespread adoption of spot pricing?
Yvonne Zhang (YZ): The market has clearly moved towards spot pricing away from bilateral fixes. I would estimate the proportion of business transacted by bilateral contracts and spot is now about 3 to 7. In terms of the physical volume on the spot market, it has moved from a couple of thousand metric tons to over 1 billion tons in a little over 6 years.
Do you sense that the market is now accustomed to persistent volatility in iron-ore and ferrous metals?
Youngjin Chang (YC): Since 2008 and the trend towards spot price, volatility in the ferrous space has become the new norm. This has a knock-on effect on the demand for swaps and options contracts as clients still seek price stability, particularly in a year like we have just experienced with a big downward price swing.
We are starting to see more commercial interests who had previously been against the idea of hedging, now getting involved or looking at it very closely. For example, the recent announcement that top steel makers ArcelorMittal and Tata Steel are ready to use derivatives is significant as its shows the practice is becoming mainstream.
We are also seeing more trading from early adopters such as Cargill who are increasing the size of their business and risk management activities. There is also growth beyond multi-national corporations. In the U.S., even midsized commercials such as Worthington Industries and Flack Steel have been known to hire full time risk managers. In China, ferrous derivatives are no longer a new topic for the industry.
Q – Do you expect China will continue to dominate activity in the iron ore market despite the economic slowdown?
YC: Yes, despite the growth slowdown in China, it still accounts for 50 percent of global crude steel production, which means naturally it will consume a similar proportion of global iron ore. China still has a lot more buildings and infrastructure to develop as it continues to urbanize, especially outside of its coastal cities. We expect China will remain the dominant consumer and continue to play a critical role in the global iron ore market.
That said, we expect some tapering-off in demand as China consolidates more steel mills and the influence of domestically generated scrap metal grows.
Q – What kind of trading activity are you seeing? For instance, are iron-ore miners, steel makers or steel end-users looking to hedge, or are you seeing more speculative activity by hedge funds?
YZ: A big difference we are seeing is that “hot money” is no longer prominent due to a general tightening in liquidity. This means that markets are more driven by industry fundamentals, which we believe is a positive development. Now commercials and industry participants, rather than the hedge funds, are driving the market.
YC: I would add this also depends to some extent on what region we are talking about. In the U.S. recently we have seen interest from both hedge funds and commercials due to large price swings.
Q – Where do you see the focus of the market – China demand or the supply picture?
YC: We anticipate supply will be more of the market focus, as there is a lot more variability to this and different shut down points for high-cost miners. As we all know, mine developments are multi-year projects and in the next couple of years there will be several new projects coming on stream bringing additional capacity. Many miners re-invested to expand capacity due to elevated pricing. At the same time, we have seen the entry of many higher-cost junior miners, which may have to close if the price downward pressure continues.
Q – Are Chinese institutions becoming more willing to use derivatives to hedge or take positions? What are the latest regulatory developments here?
YZ: While China has not updated the list of counterparties that can trade commodities offshore, we are seeing more Chinese conglomerates offshore being able to participate to hedge their own books. We would also highlight other initiatives moving the market forward such as expanded efforts to liberalize through free trade zones.
The Shanghai Free Trade Zone is expected to have eight international platforms to trade commodities including oil, gas, iron-ore, cotton, liquid chemicals, silver, bulk coodities and nonferrous metals in the zone by 2015. The State Council has also approved further free trade zones in Tianjin, Fujian and Guangdong. This is very encouraging as they are important pricing points for iron ore, coal and ferrous finished products.
Q – Have correlations across iron-ore, steel and finished metals held up during the recent correction?
YC: No, not necessarily. There are also regional differences in the same product as well. This is one reason we offer the complete suite of different products (‘virtual steel mill’ concept) along the different supply chains to mitigate price risks.
Q – How do you see regulatory initiatives playing out in China? Should we expect China to be establishing benchmarks and pricing going forward?
YZ: China is the world’s biggest metal user and producer so it will clearly contribute a lot of liquidity to the market. But it is not simply a case of China flexing its muscles and setting a new benchmark – a benchmark needs to be adopted by a majority of market participants. China is becoming more international but there is more to do in this regard.
Q – Should we expect scrap steel to play a bigger role in the ferrous markets – even in China?
YC: Yes, as China’s economy matures and its technology develops, scrap will become increasingly important. But it is not always possible to simply substitute iron ore with scrap as various factors must be considered such as technology, operations and the sensitivity of transportation costs. Despite this, we expect scrap will move towards becoming a substitute for iron ore demand.
Q – CME Group recently launched a 58% iron-ore contract. Can you explain the rationale for this?
YZ: This contract was launched to better serve Asia where the physical iron ore used in mills (especially in China & India) tends to be of lower grade quality. This new contract allows us to better respond to clients’ needs, particularly when trading between the physical commodity and the 62% contract had already diverged so much.
Q – Are you expecting to launch any new ferrous metals contracts next year?
YZ: We do recognize from speaking and interacting with our customers, there is increasing global connectivity and a desire for trading where geography is not a restriction. We are constantly talking to market participants and any new ferrous metals contracts will definitely be in response to the evolving risk management needs of our customers.