And going by the performance of the Singapore Exchange’s (SGX) 65% Fe iron ore futures contract so far this year, it is serving its purpose.

On average, more than a million tonnes worth of the contract have been traded every month since its December 3, 2018 launch.

On Monday July 1, some 270,000 tonnes worth of the contract were traded, underlining market participants’ interest in it amid a narrowing of the price gap between 65% Fe iron ore and 62% Fe products.

According to Fastmarkets MB data, the spread on Monday - at $7.85 per tonne - is its narrowest since September 2016.

62% Fe vs 65% Fe price spread


Market participants were enthusiastic about Monday’s traded volumes. Some traders said the contracts performance augurs well for its future.

Fastmarkets MB takes a look at three key ways in which the contract, which is settled against the Fastmarkets MB 65% Fe Iron Ore Index, has made a difference in the market and work out how useful it is in the future.

Transparency
High-grade iron ore prices have averaged higher in the second half of the year compared with the first half over the last two years amid the roll-out of measures to protect the environment by top consumer China.

With demand for high-grade ore already being driven by Chinese steelmakers’ healthy margins in 2017 and 2018 that led to them posting record profits for the period, the “green” regulations that emerged became the icing on the cake.

The forward curve of the SGX 65% Fe iron ore derivative contract currently shows that the high-grade market is in a backwardation. This outlook ties in with expectations that prices for physical iron ore will correct in the months to come as supply from Brazil and Australia improves.

The SGX, which is the largest exchange outside of China for iron ore trading, typically attracts institutional investors with exposure to the physical market. This is often cited as the reason why trading activity on the SGX is considered to have a better association with the physical market than that on China’s Dalian Commodity Exchange, the world's largest iron ore exchange by volume.

Last month, Asian mills and traders accounted for 50% of trading activity for the SGX’s high-grade derivative, while banks, iron ore producers, brokerages and international traders accounted for the remainder.

The emergence of a forward curve as a result of the SGX’s contract provides market participants - consumers, producers, traders and investors - with a reliable and transparent gauge of what the future may hold.

For instance, the front-month curve on the SGX suggests a strengthening of prices in July before a correction in the latter part of the year.

This trajectory aligns with physical market participants’ expectations that steelmaking restrictions in China that are based on environmental protection, and the narrowing of the price gap between mid- and high-grade iron ore would fuel the uptake of high-grade products in the coming weeks.

Hedging
The other key benefit of the SGX’s 65% Fe contract - which is in fact the primary purpose of most derivatives - is that it allows market participants to hedge their exposure to prices for physical high-grade iron ore.

This existed prior to the launch of the 65% Fe contract as well, through the SGX’s 62% Fe iron ore contract. But the divergence of prices for mid- and high-grade iron ore over the past 2-3 years necessitated a more seamless tool.

That is not to say that high-grade ore will always command a steady premium over lower grades, however.

The price spreads across grades are a function of several dynamic factors, such as the global mix of available products, steelmaking margins and, to no small extent, Chinese government policy. The fluctuation of spreads between grades and the underlying factors governing this contribute to active trading of derivative contracts.

This was apparent in April this year when volumes for the 65% Fe contract surged by 84% on the month to 1.4 million tonnes as the outlook for spreads began to change amid a seasonal shift in demand and the piquing of market participants’ interest in the price gap between the 62% Fe and 65% Fe segments.

The same holds true for May as well. Volatility in the 62-65% spread generated more trading interest in the 65% Fe contract. The SGX said it cleared 1.6 million tonnes worth of the contract in May, up 15% month on month.

Last month, the spread between the Fastmarkets MB 65% Fe Iron Ore Index and the Fastmarkets MB 62% Fe Iron Ore Index began to narrow after Rio Tinto cut its shipment guidance by 13 million tonnes.

The announcement aggravated supply concerns further for the mid-grade segment. Premiums for Pilbara Blend fines rose to a high of $5.65 per tonne toward the end of last month, compared with $2.50 per tonne in early June.

Niche segments
The high-grade segment of the iron ore market comprises not just fines but also products such as concentrate and pellets.

This year, market participants have started to price long-term contracts for pellets against the Fastmarkets MB 65% Fe Iron Ore Index.

Concentrate cargoes are also being offered against the same index.

The iron ore market has, over the past few years, demonstrated its affinity for granular pricing references that are more aligned with the underlying product, and recent trends in the pricing of pellets and concentrate underline the likelihood of market participants sticking to this.

The rising adoption of the Fastmarkets MB 65% Fe Iron Ore Index for the pricing of pellets and concentrate - and not just Brazilian high-grade fines - has made the SGX’s 65% Fe contract a tool that provides a seamless mechanism to manage price risks for an even more diverse set of iron ore products.

What's next?
While the iron ore market is better equipped to manage risks today than it was at the same time a year ago, the drivers of the current market are quite different from what we have seen over the past 2-3 years.

Chinese steel mills’ high profitability and robust demand amid supply-side reforms in the steel sector were the primary drivers of prices over the last couple of years.

But this year, prices have been governed by supply disruptions, mainly in Brazil and partly in Australia.

Brazilian iron ore exports Jan-May 2019

Australia Iron Ore Exports Jan-May 2019

Supply disruptions aside, steel production in China has so far beaten expectations this year.

The country produced 405 million tonnes of crude steel in the first five months of the year, up 10.3% year on year, according to data from the World Steel Association.

This growth came in the wake of government stimulus in the country.

Local governments in China have issued around $180 billion worth of bonds in the January-March period, an indication of Beijing’s support for the infrastructure sector. This is a positive sign for steel demand, and in turn, that for its principal raw material.

China’s steel industry today is a different beast compared to what it was a few years ago. Mills are now used to profitability and the government too is demonstrating its eagerness to lend support through policy.

The growth of iron ore trading activities at Chinese ports over the past few years is also an important factor that affects supply-demand dynamics, and in turn prices for seaborne cargoes.

In recent weeks, the dwindling of port stock has kept seaborne iron ore prices elevated despite mills’ steadily narrowing margins.

Periodical restrictions on steelmaking operations to cut emissions show that the eco-friendly path that China embarked upon three years ago was not an aberration.

These restrictions, such as the ones that were put in place in Tangshan over the past week, can quickly affect prices.

The emergence of a diverse set of price drivers for the iron ore market and their manifestation in various levels of intensity are likely to keep the relationships across iron ore grades dynamic.

These would in turn maintain the relevance of the SGX’s iron ore derivatives for the foreseeable future.