Iron ore depreciation boosts options market

Options now account for 60% of total open interest on SGX's suite of iron ore derivatives

iron ore
In ore: scale of the collapse has taken the market by surprise

Traders have been increasingly switching to options to hedge out the downside from the 50% decline in iron ore prices over the past year from $130 to below $65, as part of a broader surge in derivatives activity linked to the base metal from small producers facing serious cost pressures.

Iron ore prices averaged $62.62 per tonne in February, down 6.8% since January and more than 50% down over a 12-month period. Lower steel output in China corresponding to lower iron ore demand as well as excess seaborne supply have contributed to the recent fall.

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While iron ore prices have been trending downwards for some time, the scale of the collapse has taken the market by surprise – for example, a March 2014 research report from Sucden, a commodities trader, predicted "iron ore prices are unlikely to hold below $100 for any length of time".

Historically, high prices have produced enormous profits for mining companies and the forward curve has been backwardated – when the forward price is below spot – so the appeal in protecting against lower prices didn't exist. But with a prolonged and painful 18-month price decline, some mining companies are looking more seriously at hedging.

"Miners have been cost cutting as far as possible," says Oscar Tarneberg, senior analyst at The Steel Index, an independent iron ore information provider. "The biggest producers have costs before freight at about $20, so can soak up lower prices while still being profitable. For smaller miners with a higher cost base, it is more of an existential issue, though a weaker Aussie dollar has helped bring down costs recently, as have lower freight rates and cheaper diesel. Raising run rates is another way some miners have been lowering unit costs, but this also exacerbates oversupply." 

Tarneberg says that against the current backdrop, options strategies may be appealing to miners. "Options are attractive for miners, or anyone selling iron ore, as a way of locking in a minimum price level while still being exposed to any potential upside," he says.

Significant figures

According to SGX data, open interest for iron ore options averaged 70 million tonnes in February, making up 60% of total open interest across all iron ore products at the exchange. And in the first two months of 2015, iron ore options volumes totalled 38.6 million tonnes, making up 31% of total iron ore derivatives volumes during the period – a significant figure given the contract was only launched two years ago.

James Wang, head of global derivatives sales at KGI Ong Capital in Singapore, says his experience reflects the data. "After Chinese New year, volumes have come back and our options volumes have increased significantly over the past few months. The current iron ore price seems too low, so buyers may come in but the price over the year will continue to be very volatile. We expect more volatility in the second half of this year."

Volatility has averaged 30% so far this year continuing last year's trend while options premiums have reduced following the decline in prices as liquidity has improved.

According to a Singapore-based banking source, there is also a natural market emerging between producers who are long optionality – sellers of volatility – and banks that want to buy volatility for hedging purposes. "The main driver for options currently is that the price is moving around a lot and volatility is chunky. Physical players are long options, so don't mind selling them to banks, which are happy buyers as they look at it from a delta-hedging perspective."

Adam Newman, head of iron ore options at Icap, says an increase in options volumes has come from steel mills on the wrong end of fixed-price term deals between themselves and producers, which caused them pain as prices fell, whereas producers benefited from that scenario.

"This has increased iron ore [options] volumes and led to physical transactions trading more on a spot basis than on fixed deals, with some steel mills taking a view on direction to lock in low prices according to their own strategy and sales price.

"Steel mills don't have an accurate forward market for their product, as rebar [a type of reinforced steel] isn't a true cost of end price, so they tend to lock in their forward price after they have made some sales. We have done several structures with steel mills and some have been just collecting premium, while others have been expressing a hedging price view over a six-month period," he says.

Tailored strategies include two or three different call and put legs that provide a profile so that steel mills know their best- and worst-case scenarios.

Mill business

KGI Ong Capital's Wang says most of his clients are steel mills in China and trading houses, but he says many trading houses have already left the market due to losses. He sees steel mills as big customers this year, as they are buyers of iron ore and can use call options to hedge against any price rise in the underlying.

Newman at Icap has also concluded some deals with producers. "Large-scale miners and producers' typical option strategy would be premium neutral collars, so buying puts and selling calls to lock in levels where they can sell their production; hedging downside risk by giving away some upside."

Lily Chia, head of product management, commodities at SGX says that as options came to market later, participants tend to be those who have been trading derivatives for some time but when used to their full potential, options are effective for more customised risk management using specific trading strategies.

Indeed, Tarneberg says options usage has grown in line with the level of understanding in the market. "Steel and iron ore companies tend to be conservative industries, wary of financial products, and often lacking in-house experience, meaning there is a learning curve.

"However, Chinese steel mills have been flexible in embracing risk management tools, as there are already several ferrous futures contracts available on Chinese exchanges, while their sales strategies tend to be shorter-term and based on monthly pricing, making the transition to fluctuating input prices easier for them.

"Trading houses, which bring experience from other commodities to the iron ore space, are major players. Miners have been slower in using swaps or options in their trading strategies," he says.

Newman says there is good options liquidity at the exchange up to two years until December 2016, but any further out is the domain of banks in the OTC market managing the risk themselves. However, 90% of the market is conducted OTC often via brokers, and cleared at the exchange partly as a result of banks retreating from the commodities business.

"Over the past 12–15 months, there has been more direct activity in light of banks pulling out, and not all of that volume went to other banks. Direct participation via the brokered market has increased, but a number of banks still have good flow from traditional customers and are warehousing that risk and managing that flow," he says.

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