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Perverse efficiency

Iron ore market shows perverse efficiency

Kevin Allison 

Iron ore was a middleman’s dream in 2012. The benchmark Chinese spot price of the main raw material of steel rose a modest five per cent during the year, but that was made up of a 37 per cent slump between January and September followed by a lurch two-thirds higher. That’s a kind of efficiency; the market was responding to changes in supply and demand. But such volatility is a nightmare for the steelmakers which actually use the stuff.

The price swings may look crazy, but they’re straight out of “Economics 101”. When final demand for steel fell last summer, demand from struggling Chinese mills fell even more, as they shrunk their iron ore stockpiles to save cash. The price crashed.

By the time the spot price bottomed out at $87 a tonne in September, roughly 15 per cent of global iron ore production was losing money delivering to China. Fortunately for high-cost producers, Chinese inventories were too thin to be reduced further. On the contrary, when demand increased, inventories increased faster. Stocks at smaller Chinese mills, which had dipped to 2-3 weeks of use by September, stood at closer to four weeks by December, according to Macquarie. Add in healthier-looking November Chinese industrial production data and it was off to the races.

Plenty of industries are subject to inventory cycles, but iron ore has an especially steep cost curve - the gap between efficient and inefficient producers. At the most expensive end, many Chinese producers need prices north of $120 a tonne to cover costs. Meanwhile, producers in Australia’s Pilbara, the source of about 40 per cent of traded iron ore, can manage at closer to $40 a tonne. When Chinese production is in excess, the iron ore price falls sharply. When more is needed from Chinese producers, the price rises fast.

Iron ore used to be mostly traded on annual contracts, but in the last few years spot pricing has taken over. Its volatility is a headache. The contracts, which were negotiated in secrecy, are unlikely to return, but a futures market would give both miners steelmakers a way to stabilise prices. No wonder that Chinese planners have expressed enthusiasm.

First Published: Sat, January 05 2013. 00:30 IST