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Scenarios of what could happen after Japan iron ore deal

There is potential for a paradigm shift beyond last year's watershed with two benchmarks set by two suppliers. They are not only talking about moving the goalposts, they may change the shape of the ball.

Author: Nick Trevethan
Posted: Tuesday , 26 May 2009

SINGAPORE (Reuters) -

Global miner Rio Tinto Ltd (RIO.AX: Quote) (RIO.L: Quote) has agreed a cut of 33 percent in contract fine iron ore prices with Japan's Nippon Steel Corp (5401.T: Quote), setting a benchmark that may be fiercely resisted by Chinese buyers.

The cut is the first decline since 2002, but it falls well short of the 40 to 50 percent reduction that Chinese steelmakers are demanding and puts more strain on the crumbling 40-year old benchmark pricing system. [ID:SYD24132]

"There is potential for a paradigm shift beyond last year's watershed with two benchmarks set by two suppliers. They are not only talking about moving the goalposts, they may change the shape of the ball," ANZ's senior commodity analyst, Mark Pervan, said.

Regardless of the result, the talks to settle with China are likely to be hard fought and will attract significant regulatory scrutiny as officials look for evidence that Chinalco's nearly $20 billion bid for a stake in Rio Tinto is influencing prices.

Analysts believe a bigger discount for Chinese buyers is the most likely outcome, with the possibility of quarterly revisions, a halfway step toward a fully fledged spot market.

Following are four possible scenarios:

CHINA SETTLES AT THE SAME PRICE AS JAPAN

China may settle 2009-2010 iron ore contract prices at the same level as Japan, but given the stream of rhetoric from China's steel industry and repeated demands for cuts of 40 to 45 percent, that outcome appears unlikely.

However, thinking politically, China could play softball in order to reassure regulators in other countries that its proposed stake in Rio has not influenced price talks in any way.

The settlement is around $5 above spot prices on a delivered China basis. "We believe China will be unhappy with this settlement, although ultimately to settle in-line, for their ongoing contractual obligations," analysts at Citigroup said.

But others doubt it will wash.

"The Chinese companies will absolutely not accept this. They will stick to their original request of 40-45 percent," Zhang Changan, consultant with World Steel Dynamics in Beijing.

CHINA WINS A GREATER DISCOUNT THAN NIPPON

Chinese mills stand a better chance of holding out for a bigger price cut as they are more comfortable buying on a hand-to-mouth basis on the spot market, and have more flexibility in steel pricing than Japanese mills that face pressure to settle as they have to set steel prices with major customers.

Giving a bigger discount to Chinese customers would irritate the Japanese mills, but would not be unprecedented as the annual benchmark prices begin to fray. Last year Vale settled with its customers early, but BHP and Rio held out for months and ultimately won a much bigger increase in prices.

Vale later went back to its customers to seek a mid-cycle increase, but was unsuccessful as its demand for more money came just as consumption and prices of commodities collapsed.

"The miners won't entertain Japanese calls for an additional cut in that instance. The contract is done and dusted," Jonathan Barratt, managing director of Commodity Broking Services in Sydney said.

CHINA WIN A GREATER DISCOUNT WITH AN OPTION TO REVIST

Chinese steelmakers this year threatened to completely abandon term supply contracts and buy only on the spot market unless they win a big price cut, and they could allow miners to negotiate for quarterly price revisions to clinch a deal.

The idea of a hybrid contract partly based on a long-term fixed price combined with an adjustable element may be the most likely outcome for Chinese talks.

"A move by the Chinese toward some form of floating or spot market is probably the most likely outcome but will depend on how well Beijing can enforce its will and make its steel industry work in a more consolidated manner," Pervan said.

"A hybrid is possible -- say a cut of 40 percent initially, but if the spot market moves above a certain threshold the discount is reduced."

CHINA FAILS TO AGREE PRICES, BUYS ON SPOT MARKET

Another outcome is the long-threatened complete breakdown in the process, in which Chinese mills refuse to renew long-term contracts with Australian miners and instead buy their ore on the spot market, at least for this year.

Given that China imported about half of the world's freely traded iron ore last year -- more than 443 million tonnes -- it would be logistically difficult to buy exclusively on the spot market, although it is clearly moving in that direction.

"Despite its 50 percent share in iron ore seaborne trade, we estimate that China is unlikely to get the 40 to 50 percent drop in contract prices it has been seeking," said Societe Generale analyst Alain William.

"That said, we see a growing risk that some steelmakers may be looking to buy on the spot market. We think this is a temporary phenomenon ... but we do not share the view that the 40-year-old benchmark system could be abandoned outright."

A number of iron ore swaps contracts have sprung up in the past year or so, including at least two that are exchange-cleared. Besides providing a reference price, swaps could allow steelmakers to hedge some or all of their exposure to price moves.

In China an iron ore trading platform is expected to be unveiled in Rizhao, a major port, creating an iron ore price index, the official Xinhua News Agency reported on Friday. [ID:nPEK191358]

Graeme Train of Steel Business Briefing in Shanghai thinks China could abandon the benchmark pricing if 33 percent is all they get.

"It is a question of whether they are going to grumble about it but accept it, or are they going to abandon all benchmarks and go to spot. They certainly seem to have had a fairly short- term approach in the last year ... saying that they are getting a cheaper price from the spot market.

"Certainly the official line from CISA and so on is that we don't like index pricing or anything to do with the spot market, but when we talk to the mills, that's not the case." (Additional reporting by David Stamway in Beijing and Miyoung Kim in Seoul; Editing by Clarence Fernandez)