Iron ore volatility forcing steelmakers to bend on hedging, pricing
China's Baosteel embraces derivatives, Japanese may follow
TOKYO -- The global steel industry is contending with an increasingly volatile market for iron ore, an essential input whose price has been on a roller-coaster ride driven by inflows of speculative investment.
At the Singapore Iron Ore Forum in late April, executives from Asian steelmakers vented their frustration at what has become an almost monthly cycle of wild ups and downs in the commodity. Some steel producers are embracing financial derivatives -- something Japanese majors had been reluctant to do -- to shield themselves from this volatility.
Spot iron ore shot up to nearly $100 a ton in February -- more than double a low below $40 plumbed in January 2016. The price then turned downward, slipping under $60 a ton this month.
Iron ore prices for high-volume buyers used to be decided by one-year contracts between mining groups and steelmakers. But as Chinese spot purchases of the commodity grew, a switch was made to quarterly pricing based on the prevailing price for immediate delivery.
Even as mine output increases have created a glut on the supply side, a combination of futures trading and Chinese money has kept the ore price gyrating. Iron ore futures debuted on China's Dalian Commodity Exchange in 2013 -- and on the Singapore Exchange in the same year -- with trading volume ratcheting up quickly. On at least one day in 2016, the amount of iron ore traded in contracts on the Dalian exchange surpassed the 1 billion tons the country imports in a year.
The commodity has attracted Chinese day traders seeking to make a quick yuan. Even faster are high-frequency traders -- funds armed with computer programs that can make thousands of transactions per second. Chinese high-frequency traders are participants in Dalian-listed iron ore futures, according to Yoshikazu Ito, branch general manager at a commodity business unit of Japan's Sumitomo Corp.
Iron ore futures have become an investment asset in their own right, one that has shown an increased correlation to crude oil. The development of the futures market has had the effect of magnifying swings in spot ore prices.
Steelmakers cannot pass on such short-term fluctuations in input costs to their customers, so the volatility spreads to their earnings. Baosteel, one of China's biggest producers of the metal, will increase iron ore swap transactions as a means of controlling price risk, according to Assistant General Manager Ji Chao.
Closing the price gap
Japanese steelmakers had been reluctant to embrace financial hedging, with one executive calling futures trading "akin to gambling." But they are finding little choice but to change. JFE Holdings' JFE Steel, Kobe Steel and others are considering joining the many steelmakers that trade iron ore derivatives on the Singapore Exchange.
The volatility in iron ore prices could also push steelmakers to change their own pricing strategies toward high-volume users. Japanese blast furnace steelmakers, favoring stable client relationships, typically revise prices for automakers every six months. But many Chinese and South Korean rivals employ short-term contracts that better reflect movements in raw material costs.
"A pricing method that delays the pass-through to steel prices has contributed to low profits," JFE Holdings President Eiji Hayashida has acknowledged, hinting that the steelmaker may re-examine how it negotiates with customers.
Established business practices in the steel industry are thus starting to bend to the new reality of the iron ore market. But the effect does not stop there. A movement away from longer-term contracts for steel would expose buyers of the metal to price volatility. Some Western automakers appear to now use derivatives to try to lock in steel prices.