The rise of iron ore derivatives

A shift in the way iron ore cargoes are priced has helped give rise to a burgeoning market for iron ore derivatives. Interest in trading the product has come from a wide range of participants, including producers, consumers and investors – making it one of the few bright spots for bank commodity desks. Jay Maroo reports

Iron ore is beginning to give rise to a market for risk management products that befits one of the world’s most important commodities. The vast majority of iron ore is used to make steel – a product integral to the construction of buildings, railways, planes, ships and myriad other necessities of the modern economy. Moreover, in recent years, seaborne trade in the commodity has ballooned thanks to strong demand from Chinese steelmakers, which are its biggest global buyers.

Despite that backdrop, it was only in June 2008 when Credit Suisse and Deutsche Bank began offering cash-settled over-the-counter swaps linked to spot prices. But since then, rising interest from a broad sweep of market participants has ensured strong growth – particularly since a significant change to the pricing of physical cargoes occurred in 2010. Across the global iron ore derivatives market, annual volumes stood at around 300 million tonnes at the beginning of April this year – up from 173 million tonnes at the beginning of April 2012, according to Credit Suisse.

“By most measures, iron ore derivatives have been the most successful commodity derivatives launch of the last decade. Volumes have roughly doubled each year since we began offering the service,” says Phillip Killicoat, a London-based commodity salesman at the bank.

Although the derivatives market for iron ore remains small compared with those for other commodities, it has proven to be one of the few bright spots for bank commodity desks, which have suffered over the past year due to a lack of hedging activity in key markets, harsher regulation and tougher bank capital requirements (see box, below). While firms have divergent views on how the market will evolve in future, the critical importance of iron ore to the global economy means this growth is likely to continue, say participants. “It’s one of the fastest growing commodity derivative markets in the world and I expect it to continue to be so,” says David Berman, a Shanghai-based iron ore trader at Swiss Singapore Overseas Enterprises (SSOE), a bulk commodities trader that is part of Indian conglomerate Aditya Birla Group.

In part, this is down to a major shift in the way physical iron ore cargoes are priced, which occurred in 2010. Previously, the price of iron ore was determined in private negotiations for annual supply contracts between major producers and consumers of the commodity – with the first deal concluded each year becoming the benchmark for those that followed. In the commodity bubble prior to mid-2008, miners became increasingly frustrated with the so-called benchmarking system, which left them unable to take advantage of booming spot prices. Similarly, as the price of iron ore collapsed in the wake of the financial crisis, manufacturers and steel mills became stuck with paying significantly higher prices for extended periods of time. That episode convinced both producers and consumers of the need to move away from long-term fixed-price deals, helping to boost trading in derivatives.

By most measures, iron ore derivatives have been the most successful commodity derivatives launch of the last decade

“People have been moving away from long-term contracts to either spot pricing or a monthly average-based contract. Subsequently, the interest and trading in iron ore derivatives has improved significantly,” says Mike McGovern, vice-president of dry bulk sales for Europe, the Middle East and Africa at Citi in London.

Price swings

Market participants note that iron ore spot prices are prone to frequent swings, with volatility having picked up since the second half of 2012. The main benchmark used for derivatives is an index of prices for 62% iron ore shipped to the Chinese port of Tianjin, which is published by The Steel Index (TSI), a division of New York-based price reporting agency Platts. The TSI index dropped to $86.70 per dry tonne on September 5 last year, having climbed to a previous high of $149.40/tonne on April 14, 2012. According to TSI, the index recovered to reach $158.90/tonne by February 29 this year, before slipping back to just $123.60/tonne by May 21 (see figure 1).

Such moves are characteristic of iron ore, says SSOE’s Berman. “Iron ore tends to overshoot, either going up or down, because of frequent buyer strikes and active speculation on the part of traders. When traders come in, they will usually significantly outbid each other and end up driving the price up by $10–20 in the span of a month. It’s a combination of those two extremes that provide this volatility, which you don’t really see in other markets,” he says.

According to bankers, the occasional bout of volatility is one of the reasons the market has proven attractive. McGovern at Citi says such price swings, along with the opportunity to express views on the future of the Chinese economy and global mining stocks, are what makes the market compelling to many participants. In addition to physical market players, iron ore derivatives have also seen keen interest from investors such as hedge funds, he notes. “When you’ve got a market that can move between the lows of last year, which were around $86/tonne and the highs of this year, which were around $160/tonne – with primary demand from China as one of its key drivers – then that’s a market that encourages interest from people trying to hedge their position as well as investors,” he says.

Traders say interest in iron ore derivatives has come from a diverse range of participants – a fact reflected by estimates of market activity by Credit Suisse. According to the bank, miners and merchants are the largest participants in the global iron ore derivatives market, with each type of firm accounting for an estimated 30% of activity. These players are closely followed by investors, which are responsible for 25% of activity, according to the bank. Other less significant sources of market activity include consumers of steel and steel mills, which account for 10% and 5% of activity, respectively (see figure 2).

Killicoat at Credit Suisse says that when the market first got started, the initial belief was that steel mills would become the major users of the product. However, such companies have been able to pass on their costs to customers, giving rise to greater hedging activity from steel-consuming firms instead. “What’s happening is the price of the raw materials in steel making, such as iron ore and coking coal, are being passed through to steel consumers such as car companies, construction firms and appliance makers, which in turn are looking towards swaps.”

Increasing trading volumes in iron ore derivatives have seemingly created a virtuous circle, with bid-ask spreads declining and encouraging further participation from other participants. “Around two years ago, it was very common to see $2–3 spreads between the bid and the offer, but now, it’s typically $1 on the front end of the curve and during peak hours, it can be as little as 25 cents,” says SSOE’s Berman.

Central clearing

The majority of iron ore derivatives trades are centrally cleared, with a much smaller proportion of transactions taking place bilaterally in the OTC market. The Singapore Mercantile Exchange, Chicago-based CME Group, Atlanta-based Ice and London-based LCH.Clearnet all offer clearing services for iron ore derivatives, but the most widely used clearing house is the Singapore Exchange (SGX). With around 95% of the cleared iron ore derivatives market, SGX has become a focus for trading activity, with daily volumes in its TSI contract frequently exceeding 1 million tonnes. Nevertheless, the market’s robust growth has caused rival exchanges to intensify efforts aimed at grabbing a slice of this business, with both CME Group and Ice launching new cleared iron ore swap and futures contracts during recent months.

Most of these products are based on the widely used TSI index, but some cleared offerings are linked to other indexes, such as the Platts Iodex, which reflects the price of 62% iron ore shipped to the Chinese port of Qingdao. Traders say the spread between the indexes is rarely significant – as of May 21 this year, the TSI index stood at $123.60/tonne, while Iodex stood at $124.50/tonne, for example. But many physical market participants use supply contracts linked to Iodex and are reluctant to take on basis risk, creating a demand for derivatives linked to it. “The Platts Iodex is particularly used in the physical world in Europe, with steel contracts having a linkage to that index – and therefore, it’s important to be able to hedge with that to have no index basis risk,” says Mikko Rusi, London-based global head of metals sales at BNP Paribas in London.

If traded volumes in iron ore derivatives continue to increase, bankers believe spread trades between the TSI and Iodex indexes could prove increasingly popular. In a move that reflects those expectations, Ice listed a futures contract with a settlement price based on the difference between the two benchmarks on February 11. “We are seeing increasing corporate enquires for buyers to use the Platts [Iodex] index, so at some point you will get a liquid spread market between Platts and TSI,” predicts Rusi.

In future, another way in which iron ore hedges might be fine-tuned is through the introduction of derivatives referencing different iron ore grades. Both the TSI and Iodex indexes reflect the price of 62% iron ore, but some market participants are pushing for contracts linked to indexes that track lower-quality 58% iron ore. Such material is cheaper than 62% iron ore – and its increasing use by smelters could create demand for 58% hedges, say firms. “As world price dynamics change, one could quite easily see sudden increased demand for derivatives on the 58% grade – and indeed, very active spreading between the two grades,” remarks Duncan Dunn, a senior director at Simpson Spence & Young, a London-based dry bulk commodities derivatives broker.

Such developments could yet be a long way off. While the idea of trading spreads between the two indexes might be attractive, it is crucial to build up a sufficient pool of liquidity in the existing 62% product first, emphasises McGovern at Citi. “There isn’t really the ability to arbitrage between the grades at this point in time. But if you launch too many contracts, then all you do is drain away liquidity,” he warns.

One thing’s for sure – there is plenty of room for further growth. Bankers estimate the current size of the iron ore derivatives market to be around a quarter of the size of the physical market. Given the strides that have already taken place, firms suggest the commodity could follow the likes of crude oil, natural gas, aluminium and copper, for which derivatives markets are many times as big as the market in the underlying commodity. “If you look at the big picture, iron ore as a market is obviously huge – in tonnage terms, it is a multiple of all the base metals that are traded on the London Metal Exchange put together,” says Rusi at BNP Paribas. “So the market for iron ore derivatives has enormous potential.”

Base metal or bulk commodity? Although the iron ore derivatives market is relatively small compared with those for other commodity derivatives, it is providing a much-needed area of growth for bank commodity desks. But the product is typically traded by companies that have exposure to a range of other products, including base metals, bulk commodities and freight, making it difficult to work out where it is best placed within a trading organisation. Major banks have different approaches. At BNP Paribas, iron ore sits within the bank’s metals division. Mikko Rusi, head of metals sales at the firm in London, says this is because clients trading iron ore are also usually active in other metals markets. “Many consumers that had exposure to iron ore also had exposure to aluminium and copper for example, so it was quite natural that they traded with the metals desk,” he says. On the other hand, Citi’s iron ore derivatives effort is housed within dry bulk commodities. The rationale behind this is the critical link between iron ore, freight and coal markets. Like iron ore, coking coal is a feedstock for steel production, while in the freight market, experts estimate around 60% of capesize vessels to be transporting iron ore. “It trades similarly to how freight is traded. If you are already used to freight trading with the Singapore Exchange [and] know the brokers involved in the over-the-counter market, it’s very comfortable for you to trade iron ore as well. Mature markets, such as base metals [that trade] on the London Metal Exchange, are very different,” says Mike McGovern, vice-president of dry bulk sales for Europe, the Middle East and Africa at Citi in London. At Credit Suisse, however, metals and dry bulk trading activities are combined. According to Phillip Killicoat, a London-based commodity salesman at Credit Suisse, the decision about where iron ore desks are best placed depends on the type of clients banks are serving. For banks whose clients are tilted towards iron ore consumers, their iron ore desk is more likely to be placed within base metals. On the other hand, if a bank’s client base is more skewed towards miners, then freight and dry bulk traders are likely to prove better bedfellows, he says.