Iron ore swaps trade swells as contracts shorten

LONDON Tue Mar 29, 2011 8:58am BST

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LONDON (Reuters) - Iron ore swaps trade will surge thanks to shorter term supply contracts gaining ground in the conservative steel industry, so far slow to arm with the full range of risk management tools to battle price volatility.

Germany's biggest steelmaker, the venerable ThyssenKrupp (TKAG.DE), told Reuters on Monday it was now looking at the market. Younger players in the Asian market have led the way, but some big hitters are still holding back.

"The number of counterparties and the trading volumes in iron ore swaps continue to grow," said Phillip Killicoat, iron ore marketing manager at Credit Suisse.

"We believe you could see an annual doubling of volumes over the next five years. The emergence of options trading will contribute to this growth."

Swaps trade got a shot in the arm when miners dumped a decades-old annual benchmark system for the steel feedstock and moved to quarterly pricing in 2010.

"The more monthly contracts take hold, the more they will be exposed to price volatility and it is likely market participants will choose swaps to hedge their exposure to this risk," said Guy Thurston, a London-based freight and iron ore derivatives broker at Freight Investor Solutions.

Even shorter term deals look inevitable to many in the industry, solidifying the need for flexible derivatives.

Iron ore swaps trading volume grew from about 7 million tonnes in 2009, the first year of trading, to over 20 million tonnes in 2010 and open interest has been building up in the last few months, according to data from the Singapore Exchange.

More exchanges are launching clearing services for iron ore swaps contracts.

Spot prices for 62 percent iron content iron ore, hit a record high at $193.50 a tonne cost-and-freight China on 16 Feb, and then fell to $164.50 a tonne on 15 March, their lowest level since November 2010, according to the Platts index.

Iron ore spot prices were at $168.30 on Monday.

FINANCIALS FIRST, INDUSTRY FOLLOWS

Financial investors have been among the first to enter the market, but more industry players are getting involved.

"We are seeing ... more enquires from steel mills and producers," said a Gareth Hudson, a Singapore-based iron ore broker at London Dry Bulk. "These players will be key to the future growth of the market."

Banks and brokers said enquiries from big players were discrete and low key but pointed to firm interest.

"If steel companies wish to protect margins and offer price stability as raw material pricing goes monthly... then they must best manage inventory and seize the price risk management tools that are available to them," said Mike Walsh, managing consultant with Hatch Beddows.

"This includes iron ore swaps."

While Thyssen watches the market, ArcelorMittal (ISPA.AS), the world's top steelmaker, held aloof.

"We are not looking into usage of swaps to manage cost volatility of iron ore," a spokesman said. Swaps might bring the speculative distortion of fundamentals that regulators have identified in other more developed commodity markets, he added.

"We are rather concerned that swaps and other financial instruments could lead to a dilution of iron ore prices that do not reflect anymore the real balance between demand and supply."

Many steelmakers worry the development of iron ore swaps would entail a loss of control of the business and contact with their customers, Ian Christmas, director general of the World Steel Association, told a session of the Reuters Mining and Steel Summit.

Steelmakers also worry this could translate into financial intermediaries gaining more from the value chain, he added.

Iron ore miners are also divided.

Top global miner BHP Billiton (BHP.AX) BHP Billiton was one of the first industrial players to trade swaps and it remains supportive of this market, a spokesman for the company said.

But Brazil's Vale (VALE5.SA), the world's top iron ore miner, is not using swaps. It believes that the quarterly physical pricing system is good enough to predict prices.

But smaller miners have started to use iron ore swaps as a way to finance their operations and as a tool to manage price volatility, brokers said.

"BHP trades openly but it is my understanding that some of the other miners are going through the banks to access to the market," Thurston said.

"They can package their iron ore swaps trading with other related financial deals they may have in place with the bank."

(Editing by William Hardy)

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