A NEW DIMENSION: Why the launch of the SGX 65% Fe iron ore derivatives marks the next phase of evolution for the market

The recent launch of 65% Fe iron ore derivatives on the Singapore Exchange (SGX) marked an important step in the evolution of the modern iron ore market, allowing industry participants to manage exposure to future fluctuations in the prices of high-grade products.

Prices for iron ore, a raw material of variable quality, have always been stratified according to Fe grade. It is what makes the successful development of a 62% Fe benchmark - and derivatives contracts - following the demise of the annual contract pricing system such a remarkable accomplishment for the industry.

But in recent years, the magnitude and volatility of the omnipresent price differences between product types and grades appear to have amplified. A narrowing of price spreads between the different grades of iron ore during the cyclical downturn of 2015 followed by a widening of these spreads in the post-2016 recovery years demonstrate just how responsive inter-grade price dynamics are to changes in market fundamentals and policy.

For example, the spread between the Fastmarkets MB 65% Fe Iron Ore Index and the Fastmarkets MB 62% Fe Iron Ore Index went from its January 2016 low of $0.88 per tonne to its September 2018 high of $29.02 per tonne - more than a 30-fold increase.

The spread has since contracted to under $15 per tonne as of January 2019, highlighting its volatility.

As participants in the physical market grappled with this shape-shifting market, the adoption of more product-aligned pricing mechanisms increasingly became the solution. In most cases, buyers and sellers of high-grade products settled on referencing the 65% Fe index in their contracts, rather than constantly renegotiating premiums to the 62% Fe index.

Today, the Fastmarkets MB 65% Fe Iron Ore Index is the settlement benchmark for the iron ore market’s largest-value product stream - Vale’s Iron Ore Carajas (IOCJ). This is also the most frequently traded high-grade product in the spot market and drives price discovery in the segment.

However, the high-grade market as a whole extends further, with around 500 million tonnes per year of global, ex-China iron ore supply grading above 63.5% Fe. This volume also includes pellets and concentrate, though Fastmarkets MB’s analysis shows that prices for these products correlate more closely with the 65% Fe index than with the 62% Fe one.

This means that the new SGX derivatives would constitute a lower-basis-risk option for market participants seeking to manage price exposure to all products in the high-grade sphere.

But while participants of the physical market have adapted their pricing mechanisms to better suit today’s complexities, the derivatives arena continued to be dominated by the 62% Fe grade. The intricacy of the modern market is such that the 62% Fe index - once an acceptable proxy for prices across the grade spectrum - is now only truly reflective of a particular grade bracket, albeit a large one.

Though the focus around a single grade reference was a crucial component in supporting the development of a liquid derivatives market for iron ore, the industry now has the opportunity to broaden its perspective in line with the changing physical market structure for evolution to continue.

The new SGX contract, settled against the monthly average of the Fastmarkets MB 65% Fe Iron Ore Index, will help industry participants manage their exposure to high-grade iron ore more efficiently. It also adds another dimension for traders seeking to take views on how inter-grade price spreads change in the future in response to market dynamics.

In this paper, Fastmarkets explains the drivers that affect prices for high-grade iron ore, the factors to consider when looking to predict future movements in the spread between the 65% Fe and 62% Fe indices, and the way macroeconomic data may be used to inform decisions around trading the new contract.

Fastmarkets iron ore - A new dimension
Click on image to access

Peter Hannah

phannah@fastmarkets.com

Published

Peter Hannah

January 31, 2019

07:55 GMT

Singapore