Pricing distortions in the iron ore market

The three big iron ore mining companies - Vale (16.6% in 2008), Rio Tinto (10.8%) and BHP Billiton (7.2%) - dominate the global iron ore production, with more than a third of the production. Adding to their market power is the fact that the remaining producers are very small and with limited ability to influence the market. All the aforementioned, coupled with formidable entry-barriers (capital investments required), means that the global iron ore market has all the characteristics of an oligopoly.

It is in this context that a recent radical change to the way that iron ore is priced should be seen. The Economist reports,

"For the last few decades, iron-ore contracts have operated on an annual basis, which gave buyers a degree of pricing certainty. In the last month, however, mining companies – led by the UK's BHP Billiton and Brazil's Vale – have forced steelmakers to switch to quarterly contracts so that they can respond to market conditions better. That makes steel prices harder to predict. As a key end user of steel, the automotive industry is particularly exposed to this price volatility... Mass carmakers are particularly badly affected, because the metal accounts for a higher proportion of their end-prices."

The massive Chinese purchases too have contributed towards the break-up of the traditional benchmark pricing system (where the few large miners and steel makers arrived at a mutually acceptable rate). The Chinese, who made up 45% of the global steel consumption in 2009, have refused to accept the secret deals, and have preferred to make large purchases on the spot market. While this has boosted the spot market and various hybrid pricing contracts, it has also had the unintended effect of increasing price volatility and thereby hurting the auto-makers in particular.

This volatility comes even as the global demand, especially from the emerging economies, shows signs of recovering. The Economist Intelligence Unit has forecast that the price of steel will average US$568 per tonne in 2010, compared to US$489 in 2009 and US$889 in 2008.

This volatility (with an upward bias) makes longer term pricing strategies unremunerative for the producers, who stand to profit from the short term price fluctuations with a flexible pricing strategy. However, end users (like automakers) who found the certainty associated with the benchmark pricing strategy attractive, are now feeling the brunt of the price volatility.

In this context, standard principles of contracting would have it that price risks should be borne by those who are able to bear it at the lowest cost. An extension of this arguement to the price volatility risks facing iron ore producers and end-users would suggest that the later are less well-positioned to bear the risk. This would mean that a more transparent long-term benchmark pricing strategy is the most efficient pricing contract.