FOCUS: High-grade derivatives will usher in next stage of evolution for iron ore

The time has come for a high-grade iron ore derivative amid structural changes brought about by the Chinese government’s 13th five-year plan (2016-2020) that has piloted an era of environmentally friendly growth for the world’s largest iron ore buyer and steel producer.

The reasons that have driven physical demand for high-grade iron ore are well understood by stakeholders in the iron ore market.

High margins seen by Chinese steel mills since 2017 have driven a productivity drive leading to a preference for higher-grade iron ore.

This sustained demand has led to grade differentials and is being seen by top iron ore producers as a structural change in the market rather than a cyclical one.

With the physical market centering its focus on the high-grade segment, there is increased clamor among participants for a suitable mechanism to hedge against the price risks that they are exposed to.

The Singapore Exchange (SGX), which accounts for a bulk of the liquidity in the iron ore paper market through its suite of derivatives, told Metal Bulletin earlier this year that it sees the need for a contract for high-grade iron ore owing to the changing market conditions.

While the exchange has not made official any plans to launch a product for high-grade iron ore, participants in the market are unanimous about the need for it.

“The launch of a high-grade derivative will usher in the next phase of evolution for iron ore,” Jamie Pearce, the executive director of SSY Futures, said.

Andrew Glass, Anglo American’s head of trading, said that a dollar-denominated high-grade iron ore derivative would go a long way in meeting the requirements of the value chain to reduce basis risks related to the segment’s exposure amid volatile spreads.

A number of other compelling reasons on why the time is ripe for a high-grade iron ore derivative have also emerged.

“A hedging mechanism is important from the perspective of providing transparency and accessibility to the investment community as it establishes a physical-paper market relationship,” Jeremy Goldwyn, managing director at Bands Financial, said.

Risk management
At the moment, the bulk of the liquidity in the ex-China iron ore derivatives market centers around the SGX’s contract for 62% Fe iron ore.

However, with the spreads between the 62% Fe and 65% Fe grades seeing increased volatility, market participants say that derivatives based on the former are no longer sufficient to meet all of their hedging requirements.

“At the moment, we have to hedge the physical high-grade cargoes with physical trades of the mid-grade cargoes and then hedge those against the 62% derivative as there is no hedging mechanism offered by any exchange for high grades,” a trader source in Singapore said.

“This method of hedging is cumbersome and a derivative will go a long way in making the hedging process seamless,” he added.

Pearce said that the current tools available for risk management do not allow a perfect hedge, and leave market participants exposed to risks amid volatility in the high-grade segment.

A Shanghai-based trader echoed the sentiment.

“A high-grade derivative will help a lot because right now, we are forced to leave some of our volumes unhedged,” he said.

Glass said that besides serving as an efficient risk-management tool for those with exposure to the 65% Fe iron ore fines segment, a high-grade derivative would also be useful for those trading in other materials such as iron ore concentrate.

“At the moment, if you are selling a concentrate cargo on a fixed price basis, the only way to hedge it is using the 62% Fe derivative and that leaves people exposed to massive basis risks because the two sectors can move quite differently,” Glass said.

“We could see more fixed-price trades involving high-grade products if there is a suitable hedging tool available for that segment,” he added.

Volatile markets’ draw
Market participants also argue that derivative contracts work well in volatile markets, and given that China’s demand for high-grade ore is in line with its environmental protection measures, this is the segment that is likely to experience volatility when the Chinese market responds to government policies.

“[…] the Blue Sky program has the potential to amplify intra-year volatility in the supply-demand balance, even if it does not translate into equal volatility in mill margins,” Huw McKay, BHP’s vice president for market analysis and economics, said in a report recently. In the report, he drew attention to the persistence of grade-differentials in the iron ore market.

The spreads between the Metal Bulletin 62% Fe Iron Ore Index and the Metal Bulletin 65% Fe Iron Ore Index underline the point on volatility.

“The 62% contract has been quite rangebound this year whereas the differentials have been a lot more dynamic, and that is what attracts the traders,” Glass said.

“The sustained lack of volatility in the 62% segment may discourage hedge funds or banks from participating in the paper market while the launch of a high-grade derivative would help keep the interest intact,” he added.

Pearce concurs, saying that traders would always gravitate toward volatile markets and that makes a strong case for a higher-grade derivative and augurs well for its success.

“An outright 65% contract would be the most straightforward way because traders would be able to execute the hedge with a single contract, instead of executing two trades (the 62% and the spread contract) to cover their exposure in the high-grade segment,” Glass said.

Price spreads
Metal Bulletin’s 65% Fe Iron Ore Index is being hailed by market participants as the natural choice for the basis of a high-grade derivative contract, with the bulk of transactions involving 65% Fe fines being priced against the index in the market.

“The general feedback from the market that we hear is that a large portion of the physical trading is based on the Metal Bulletin 65% Fe Iron Ore Index, and that makes a strong case for it to be the basis of the derivative,” Pearce said.

A second trader source in Singapore pointed out that physically delivered contracts force the convergence of prices in the physical and paper markets. For cash-settled contracts, this effect is best achieved if the financial contract is settled based on the price used in the physical contracts, he added.

Gateway to China
With China’s demand for high-grade ore being acknowledged as a structural change, a part of the market is of the opinion that the steelmaking raw materials segment may emerge as a more widely recognized gauge of the country’s macroeconomic health.

At the moment, that position is occupied by copper, a higher-value product compared with iron ore with more standardized delivery standards.

Pearce argues that hedge funds in offshore markets already use the SGX’s iron ore derivatives as a way to express their view of China’s macroeconomic outlook.

“Iron ore already serves as a proxy for the macroeconomic health of China for those who cannot or do not want to trade the onshore market,” he said.

Glass argues that there is an array of ways through which overseas investors can express their position on the Chinese macroeconomic growth story and off-shore iron ore derivatives is one of them.

Goldwyn said that the “‘virtual steel mills’ will definitely find a way to express their view on the macroeconomic health of China if there are derivative options available for steelmaking raw materials and steel products.”

The SGX has been endorsing the virtual steel mill model to offer a suite of ferrous derivatives largely because of the segregated nature of the upstream and downstream ferrous markets.

This is unlike the case of derivatives for base metals, including copper, where the norm is for a single product to be used as a hedging mechanism by participants across the value chain, such as copper smelters and copper fabricators.

The size of the iron ore market and the intra-product volatility both make it conducive to a wider range of derivative products, compared with base metals, Goldwyn added.

The short-term pricing mechanism of iron ore also lends itself well for a paper market, a copper market analyst told Metal Bulletin.

Dalian impact
The opening up of iron ore futures traded on China’s Dalian Commodity Exchange to foreign investors earlier this year did trigger some talk about the possible stifling of liquidity on international exchanges.

Iron ore prices traded on the DCE are seldom considered an accurate gauge of the physical market levels amid a dominance of retail investors or speculators on the onshore market.

The opening up of these futures to foreign investors is expected to boost the participation of physical traders, including producers and end-users, thereby making the iron ore price discovery on the exchange more linked to physical market prices.

Market participants have raised caution about obstacles, however.

“The opening up of Dalian has not seen western funds trading [in] the onshore market. On the other hand, we have seen a dip in open interest for iron ore contracts on the DCE recently,” a market participant who closely tracks activity on the two exchanges said.

There might be interesting arbitrage opportunities to explore when offshore investors get access to the onshore market but it will be a slow process before the ex-China market gets actively involved because ease of access is still an issue, Goldwyn added.

A third trader source in Singapore argues that both the DCE and the SGX will have a role to play in serving the needs of the iron ore market in the future, with the SGX platform having some advantages due to its easier access for foreign investors and stable operating environment compared with onshore exchanges.

What next?
Pricing mechanisms in the iron ore market have seen significant changes over the past decade when annual negotiations gave way to short-term pricing leading to the development of daily indices, such as those provided by Metal Bulletin.

The shift to daily pricing has also led to the development of tools for price-risk management in the low- and mid-grade segments.

China’s focus on protecting its environment and accompanying strong demand for steel has established a new normal for the steelmaking raw material, with much of the focus now on the high-grade segment.

With volatile grade differentials now being a reality of the physical iron ore market, the time seems ripe for an appropriate financial risk-management tool.

Our team will be discussing the new SGX 65% Fe derivative contract in a live webinar on December 11. They will examine how changes in the iron ore market have prompted the need for this high-grade derivative, the opportunities the contract offers and the methodology behind our iron ore index. Register here:

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