The global iron ore and coking coal markets will see extreme volatility and possibly huge loss of efficiency if the annual contract prices are abandoned.
The breakdown of the annual contract pricing mechanism for iron ore and coal has not come as a surprise. The global behemoths in these resources have been talking about it for quite some time.
It was not quite noticed that companies such as BHP Billiton or Rio Tinto have already been deeply entrenched in the spot business for iron ore and coking coal.
As per some reports, BHP Billiton sold about 46 per cent of their iron ore last year on terms deviating significantly from the annual prices. Much of this could have been sold to China who had refused to sign a contract last year.
The miners whose costs do not change so much over time will test the ability of the steel buyers how far can they go now. After all, it is the ability of the steel buyers to pay for steel that will determine the price the steel makers will be willing to pay for their raw materials. The miners will work this out and adjust their prices to such a level.
In the past, the steel makers, with annual pricing contracts in hand, could expect a relatively stable cost line while faced with a variety of pricing conditions, including annual and quarterly contracts and spot. Now with the assured annual contract prices disappearing and the quarterly prices in, the benchmark most likely will be hinged on to steel prices of the previous months.
With this, what is emerging now is a regime of interdependence of steel and raw materials prices, with the players not having any clear basis to start off. While the steel makers will wait to see the raw materials prices at the beginning of every period, the mining companies will wait for signals from the steel market.
Who will blink first and take the first step will be of interest to watch. But, the wait, the uncertainty and the resultant chaos has the potential to cause a massive disruption to businesses down the line, especially if this regime is taken to its full extent.
Coking coal spot prices have had practically no correlation with the annual contract prices in the past couple of years at least. The deviations were huge. Mistakes were made in understanding the future of the steel market and everything depended on the experiences of the immediate past.
While spot coking coal prices remained on both side of the annual contracts through the year ? lower or higher than the contract prices, the iron ore spot prices have invariably remained higher than the contract. This premium was visible to all the iron ore producers and there is no reason why they should not have grabbed this.
Why have the steel makers let the iron ore miners to take hold of the pricing power? It is because of the strategic blunder the Chinese mills have made not to have signed the annual contract for 2009. They were at no fault in trying to bargain hard and act tough. But, they should not have taken this to its ?illogical end?. They were not prepared with a Plan B!
But, today, going all out to the spot market will help the Chinese mills in a relative sense. The Chinese mills have already been dependent significantly on the spot iron ore. Although they bought about 36 million tonnes of coking coal last year from the global market, they are not critically dependent on imports.
Therefore, the change to spot will not make a big difference to the Chinese steel industry. But, the Japanese, Korean or European mills will see a massive change in the way business will be conducted in the years ahead. They have annual contracts with their major customers, which will invariably go haywire if the steel makers are not sure of their costs.
The ?all spot pricing? regime will create unprecedented volatility in the market especially when there are so many exchanges running around the world to make future deals. The speculative forces are strong and efforts to hedge rising prices will create more disturbance in the absence of sufficient information and knowledge of the market.
(The views are personal)