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Goldman Sachs’ latest comments on the steel industry and its raw materials pricing will make headlines.
The bank’s analysts believe that the iron ore market could revert to annual benchmark pricing within the next few years if quarterly mechanisms are abandoned.
“It would not be surprising to find the industry revert to the old annual contract system within a few years, though an attempt to move to a pure spot market first is possible,” Goldman said in the report.
With the exception of a few, most iron ore contracts are now being agreed on a quarterly basis, with pricing being determined by the average of indices during a prior reference period.
Vale, Rio Tinto and BHP Billiton are all selling material on these terms.
But, now that spot market prices have fallen below third quarter contract levels, some market participants believe more and more steelmakers will ignore the new arrangement and buy iron ore on the spot market.
If it happens, this won’t last long, Goldman Sachs believes.
“While the old, annual contract system may not have been perfect, the new system appears flawed too,” the investment bank said.
“It uses a very thinly-traded spot iron ore market, which has accounted for only 10-15% of trading volume in the past… (around 20% currently) to set pricing for the balance of the market – which does not really imply market-based pricing.”
Goldman’s theory seems to be based on pretty murky thinking, however.
A move back to the old system, whereby the vast majority of steelmakers would accept a price negotiated by a small number of larger mills, doesn’t exactly imply market-based pricing either.
And it’s not really fair to call the spot market small. The bank’s estimate of a 20% share still puts the spot market at around 240 million tonnes of an overall market of 1.2 billion tonnes. That’ pretty significant.
That’s why the growing spot market has been such an important ingredient in the evolution of contract pricing. Without the spot market, miners have few tools to efficiently determine the value of their output. They’re not likely to abandon it.
But the market isn’t just small, it’s also inflated, Goldman believes.
Over the past few years, some smaller steel mills have been “willing to overpay” because they were circumventing currency controls or they “were willing to get iron ore at any cost simply in order to survive”, it said.
And Chinese policy had an unnatural affect, though, Goldman maintains.
After Beijing directed that mills smaller than 5 million tpy should be taken over by their larger brethren, “smaller mills had to grow their size quickly in order not to be taken over, which as possible only with a guaranteed supply of iron ore”.
But, whether or not this is the case, the spot market is still reflecting supply and demand mechanics. It’s naive to suggest that any market operates in a vacuum, never mind the market for iron ore.
Now for the most contentious part. Goldman has serious problems with index-linked pricing, targeting one index provider in particular.
“As the spot prices are based on an index compiled by an industry publication (Platt’s), which collects such ‘spot prices’ by calling up traders, we think there could be an inherent problem of bias,” it said.
“Iron ore traders – like traders everywhere – like to talk up their book, and are likely to quote prices that they want to see published, thus making them self-fulfilling prophecies,” the authors explained.
This is unfair.
First of all, traders aren’t always sitting on a long position. When they’ve sold a cargo short, they’re just as likely to talk the market down so they can secure a better price on their purchase.
In fact, long- and short-selling as conducted by traders is generally considered to help keep commodity markets within reasonable value limitations.
When something’s oversold, traders bring its value back in line by buying it back up. They sell markets down again when they’re overbought.
It’s a strange tack for Goldman to take, particularly given the flak investment banks have been getting over their own proprietary trading operations.
Also, suggesting that annual benchmark negotiations, conducted by a relatively tiny number of market participants, are less open to influence than the spot market seems a bit silly.
And not every index is the same.
Most indices are calculated using data on transacted business, not just on info procured from discussions with traders over the phone, according to Metal Bulletin Iron Ore Index (MBIOI) director Cameron Hunt.
“There are mechanisms built in to allow for this,” he explains.
Goldman’s comments will be popular. It’s obvious that many steelmakers aren’t happy about the move away from annual pricing. And who can blame them?
Annual pricing brings balance sheet stability and, theoretically, allows mills to offer longer-term prices to their own customers.
And increased cost volatility will also undermine steel company valuations.
“The markets are unlikely to pay a higher multiple for the lower visibility of earnings,” Goldman said. “Combined with the uncertainty of sales volumes and prices, mining companies could, after a trial period of two or three years, find that it is in their own interest to go back to the annual contract system.”
But that’s not really the point. The move away from the old system didn’t come from nowhere. And not all of the miners were happy about the change.
There are obvious benefits for both sides in moving back to annual pricing. But there are major potential pitfalls as well.
If steelmakers start ignoring quarterly contract prices, instead buying material for less on spot, it’s extremely unlikely miners will be able to convince them to honour annual-agreed pricing next time the spot market takes a dive.
Confused yet? Let’s recap.
Goldman believes the spot market was inflated by smaller Chinese mills and is not representative of the real value of iron ore.
Whether or not this is the case, at 20% of world trade, the spot market is pretty important. And it’s easy to argue that it provides a more efficient valuation for iron ore than the benchmark system.
Goldman believes that indices can be influenced by traders.
Not fair. Most index providers have developed robust methodologies designed to prevent this kind of interference, and the bank’s analysis doesn’t seem to have included sound thinking on real-world market dynamics. At face value, the annual benchmark system doesn’t seem to be any better.
So will iron ore prices end up settled on an annual basis once again? Very possibly.
What’s more important, though, is what happens in the next couple of quarters if the spot market continues to trade at a discount to quarterly contract pricing.
Any thoughts? We want to hear them. Let us know by commenting on the story, send us an email at editorial@metalbulletin.com, or start a discussion at MB’s Linkedin page.