The Rise Of Commodity Indexation

The pricing of iron ore experienced a massive change over the past decade as China's ascendancy to become the world's second-most important world economy caused a complete shock to the system. Meanwhile, markets for metallurgical coal are moving toward a closer-to-market price, which poses the question as to how an index for finished steel products might be more widely used.

Iron ore and crude steel are both products that lead increases in the intensity-of-use of commodities. China has been an obvious case in point — as the "factory of the world," the nation now consumes more than half of the world's crude steel and iron ore each year.

China's economic growth was the main cause for the challenges that the historical iron ore benchmark pricing system then sought to deal with. Demand and supply were forced out of a comparatively stable relationship, determined by closed-door meetings between Australian and Brazilian producers and Japanese steel mills (JSMs). With volatility and a new major source of demand, new contractual relationships were forged and trust between buyers and sellers was growing from a new base. China was unprepared to accept the contractual pricing levels that Japan settled in 2009 and began to make spot purchases in large quantities — the liquidity of spot markets grew quickly as a result.

This developing market environment required a new system simply because the old system, built for different circumstances, no-longer worked. As then-marketing chief for Vale SA, Pedro Gutemberg, commented in March 2010, "the benchmark system didn't survive a serious test" in 2009, and miners were forced to change pricing mechanisms in order to avoid a "never-ending confrontation."

The catalysts for change in metallurgical coal markets

Unlike iron ore, what spurred the push toward indexation away from the quarterly benchmark system, was not only Chinese demand, but also continued supply disruptions in Australia.

China, particularly over the past five years, has varied the quantity of its imports wildly. These volumes peaked in 2013, according to S&P Global Platts, at approximately 75.4 Mt, before falling sharply to 48.0 Mt by 2015. Imports subsequently returned to levels above 70.0 Mt in 2017 — due mainly to a dynamic program of national coal supply reform. China's volatile purchasing patterns have had an impact on global pricing mechanisms by increasing the volatility of metallurgical coal spot pricing — steelmakers and miners found it hard to agree a fixed price for any one calendar-quarter.

A larger catalyst of change within the coking coal market was with supply disruptions, and weather conditions in Australia were of chief concern. Multiple disruptions to mining operations in Queensland in the second half of 2016, in addition to the arrival of cyclone Debbie at the end of March 2017, caused spot coking coal prices to rise dramatically.

Spot prices for premium coking coal quadrupled year-over-year in 2016 and, during cyclone Debbie, Platts' premium coal prices saw their largest daily increase of US$58.50 (or 32%), to US$241/t FOB Australia on April 5. This made it almost impossible for northeast Asian steelmakers and miners to agree mutually on a fixed quarterly contract price. The quarterly benchmark price system could not be sustained due to price volatility caused by extreme supply outages in Australia and China's erratic import appetite.

Why move to an index?

For iron ore, the top three Japanese steel mills controlled approximately 80% of national production, whereas the top three Chinese producers controlled just 18% of 2016 crude steel production. With such a fragmented steel market, there was a less comfortable relationship between key steelmakers and the top three iron ore miners (Vale SA, BHP Billiton Group, Rio Tinto). With intense competition among Chinese steelmakers for raw materials, and a fragmented consumer market for iron ore, it quickly became the case that spot prices rose above longer-term contractual prices — in such situations, miners felt obliged to sell on the spot market rather than via long-term contracts.

This situation led naturally to indexation — the process where the prevailing price is assessed on a daily basis based on observable market trades. The first move was toward a quarterly lagged system — steel producers would purchase iron ore in the second quarter at the average of prices in the first quarter of any given year and sometimes lagged by a further month (i.e. four-months lagged from the start of the quarter). There were also quarterly-actual prices, whereby second-quarter prices were determined based on second-quarter averages — these provisional prices would then be balanced at the end of the quarter. Spot prices for discrete cargoes were also available, and these assessments were led by S&P Global Platts.

The trend moved to price cargoes as close to market as possible. Quarterly lagged mechanisms were useful in smoothing volatility, but were also risky. In 2012, price falls led spot prices below quarterly lagged contract prices. This volatility led to widespread default on contractual obligations by Chinese steel producers who could purchase the same cargo on the spot market at a lesser price. Prices that were assessed close-to-market had less of this inherent longer-term pricing risk.

Metallurgical coal

The use of indices in term, or spot, contracts started out much earlier, after the first daily coking coal index was launched by Platts on August 23, 2010. In 2011, some forms of indexation were understood to have been used to price coal in Australia, Indonesia, Colombia, and Russia, although adoption did not appear to be particularly widespread. The first publicly known spot index-linked contract sold to China by the largest miner, BHP Billiton Mitsubishi Alliance (BMA), was understood to have occurred in March 2011, based on Platts' premium coal indices.

The major breakthrough for indexation came about in Q3 2012, when Platts' Premium Low Vol FOB Australia prices plunged from US$225.50/t on June 26 to US$140/t on September 24, losing approximately 61% of their value within the quarter. The large price decline prompted a wave of sales via floating prices rather than fixed. "In principle, we try to achieve a fixed price, but if a buyer's and a seller's opinions are too far apart, it's [index] a good fallback," an EU steelmaker said at the time.

Index usage started to gain traction within long-term contracts as a fallback mechanism in 2013, when some steelmakers sought to adopt a 'portfolio' approach in terms of price exposure — a mix of cargos priced using spot, index-linked, and quarterly pricing mechanisms. From 2013-2016, the proportion of outright index pricing, rather than as a fallback mechanism within term contracts, increased as both buyers and sellers shifted toward a greater emphasis on a portfolio approach. Eventually, it was a combination of extreme price volatility, and a desire for shorter-term pricing from steelmakers and automakers, that effectively ended the quarterly pricing system for premium coking coals in 2017.

In parallel, northeast Asia's move toward price indexation, and away from a quarterly fixed-price mechanism, coincided with a year-over-year increase of approximately 190% in the volume of traded derivatives in 2017 — combined volumes cleared on the Singapore Exchange (SGX) and the CME Group (CME) rose to 16.2 Mt, from 5.6 Mt in 2016. The spike in the traded volumes of coking coal swaps on the Singapore Exchange reflects the growing appetite from a wide range of industry participants to protect themselves against spot price volatility.

Is indexation "good" for bulk commodities?

Overall, much of the change in demand was to the benefit of the steel raw material owners. The move to indexation was to better approximate a price based on supply and demand, given the uncertainty of a new market. Whilst there has been a dramatic increase in volatility, the extra value gained in the short-term is clear from the above graphs — contractual pricing may not have anticipated the rise in short-term value that the index created for miners.

There are a number of positive and negatives from a market efficiency point of view that occur when examining the lessons of indexation for iron ore and met coal.

What does this mean for steel markets?

With iron ore and coking coal moving toward more liquid and indexed pricing systems, the prospect of a widely-used indexed steel pricing system is becoming more plausible, in theory. There are several scenarios for what can happen next in terms of pricing in the steel market. After raw materials, steel itself may eventually be priced against spot indices. Dynamic trade flows in recent years mean the emergence of a global steel benchmark is unlikely, but regional benchmarks may emerge for the main steel products, many of which are standardized enough to go down this path. Another option would be for steel to be formulaic-priced off iron ore and coking coal, plus other costs. This was done by a number of steelmakers selling to automotive producers in Europe a few years ago, and in Japan more recently.

These trends are already catalyzing the emergence of new risk and cash-flow management techniques for steel supply-chain participants, which have been accessible, to the oil industry for many years. Another example is with copper concentrate, which is assessed using the prices of the end-products to assign value to the concentrated ore. It is possible that iron ore and coking coal could see this type of pricing mechanism evolve, with the value of mined products derived from the price of steel. This would certainly be contested by miners and mills alike, and the apportioning of profits could be extremely difficult to agree.  Plus, it may not necessarily improve market efficiency. The growing use of spot indices to pass on raw material price-risk down the chain, and of derivatives to manage this risk, are likely to form part of this evolution.

This article is a collaborative analysis by S&P Global Market Intelligence's Maximilian Court and S&P Global Platts' Edwin Yeo. Both companies are owned by S&P Global Inc.