OREANDA-NEWS. August 19, 2015.

Differentiation Matters in Iron Ore

In recent years, the seaborne iron ore market has evolved significantly and the derivatives market has deepened. With a backdrop of heightened spot price volatility, demand uncertainties, and increasing environmental pressures (particularly in China), the importance of quality differentiation in iron ore has also risen. Furthermore, the prices of products such as iron ore lump are to some extent impacted by their own seasonality and market drivers. This is discussed further below


 

Iron Ore Lump: what is it & why the premium

The main forms of iron ore used in the blast furnace-based steelmaking process are sintered fines, lump and pellets. Iron ore fines and lump are often mined from the same ore bodies, though lump is scarcer than fines. Lump typically commands a premium over fines, primarily because fines must be sintered before being used by steelmakers. Sintering can be costly, and is also widely known as the most polluting process in the steelmaking chain. Lump on the other hand can be loaded directly into the blast furnace. Lump is also easier to handle during transportation and can continue to be shipped during wet seasons (liquefaction can be an issue with the shipment of iron ore fines during wet weather).

It is estimated that the seaborne iron ore lump market was 200-250 million tonnes in 2014. Lump typically comprises around 15-20% of the iron ore that is fed into blast furnaces. In China, lump demand can vary and be relatively price-sensitive due to the availability of domestic concentrate which can be pelletized (NB. iron ore pellets may also be loaded directly into the blast furnace, though the pelletization process can be costly). In regions without domestic concentrate availability, such as Japan and Korea, demand for iron ore lump is typically more stable.


 

Lump premiums on average are rising; basis risk is growing

Iron ore lump premiums have outperformed the benchmark iron ore fines price over the past couple of years. As a result, the lump premium has on average risen relative to the price of fines. In 2014, the Platts iron ore spot lump assessment (CFR China) averaged 11.27% of the benchmark iron ore fines price, on a 62% Fe-equivalent basis. To date this year, this has increased to 18.95%, with a range of between 9.5% and 32.2% through the course of the year. Relative to the benchmark iron ore fines price, lump premiums are rising on average. Furthermore the correlation between the lump premium and the fines price is low and can be notably volatile. Over the past two years, the correlation between the benchmark 62% Fe iron ore fines price and the lump premium was just 16%.

There is an element of seasonality in lump demand, most notably in China which accounts for approximately three-quarters of seaborne lump demand. As seen above in exhibit one, in recent years, lump premiums have on average been higher during the winter in China and lower during the summer. During the winter months in China, weather-related supply constraints limit availability of domestic concentrate for pelletization, reducing substitution optionality and lowering price-elasticity as a result. The opposite is typically true during the summer. Other factors such as environmental pressures and credit availability may also impact lump demand and premiums.


 

SGX to launch Iron Ore Lump derivatives

SGX will launch SGX Platts Iron Ore CFR China (Lump Premium) Swap and Index Futures contracts on Monday 31 August 2015. The new contracts aim to provide more effective hedging tools for iron ore and steel market participants in the global iron ore lump market, particularly in light of rising relative premiums and seasonal factors. The contracts will be denominated in dry metric tonne units (“DMTU”), in line with the underlying physical market (NB. DMTU represents 1% of iron contained in a tonne of iron ore, and is used to facilitate pricing).

Illustration
An iron ore trading company that wants to hedge its iron ore lump exposure enters into two transactions:

  1. Long 50,000 dry metric tonnes (DMT) of Oct 2015 SGX Iron Ore Lump Premium CFR China Index Futures at US\\$0.1200; and
  2. Long 50,000 DMT of Oct 2015 SGX Iron Ore CFR China (62% FE Fines) Index Futures at US\\$48.00.

Please see below the workings of the contract values of the two futures transactions.