Ferrous markets and the crisis of confidence

Author Deepali Sharma, Editor – Asia Ferrous Markets

Heightened market volatility because of geopolitical tensions and Covid-19 lockdowns in China among other factors, have highlighted tensions in steel and steelmaking raw materials’ pricing as negotiations between buyers and sellers become difficult. The market has an opportunity to review the way it prices steel, iron ore and metallurgical coal, and adopt efficiencies that would serve it better over the long run.

Movements in iron ore, steel and metallurgical coal prices this year, heavily affected by market volatility, may have been good for trade(rs) on the right side of the bets. But they have raised questions about pricing mechanisms and their efficiency.

Steel exporters in China have highlighted the difficulties with payments related to their hot-rolled coil (HRC) export contracts as buyers cited weaker spot prices. The deals in question involve cargoes that were meant to be shipped in April and May and were based on fixed price negotiations at the time when prices were higher. But Covid-19 lockdowns in China that began in April slowed port activity, including at Jingtang and Shanghai, and delayed shipments. The Argus fob China HRC index was $691/t on 17 June, down by 7pc from a month earlier and down by 32pc as the previous year, meaning negotiated prices are looking less appealing. Unsurprisingly, some buyers are having second thoughts. Performance risk is on the increase.

HRC exporters now staring at contract defaults could have prevented being in this position if contracts had been linked to a physical index that tracks the spot market. While this will lead to prices “floating” rather than fixed in advance, there is now the option to lock in a forward price using the London Metal Exchange’s fob China HRC futures contract, which settles against the Argus fob China HRC index. This provides the same forward price visibility and security as a fixed price, yet without the associated performance risk if the market moves. Steel mills already use index-linked pricing for their raw materials, so the concept is not new.

Metallurgical coal markets face a different conundrum. The market uses indexes but the spot trade underpinning them has thinned. The market has come to accept the lack of spot liquidity as a given, but even the recent limited number of deals have occurred at wide spreads. This, coupled with the even wider spread between mills and sellers’ price estimates, made for some awkward talks. All sides see the fundamental factors that are affecting the market but they could not agree on the price of the day. The onus of maintaining spot market liquidity is rightly or wrongly on one key participant. Mills have become active in the spot market for price discovery, but the spread of deals on different platforms, the terms attached to them and the platforms on which they are done, have at times done more harm than good in boosting the market’s confidence in pricing.

The solutions are less straight forward for metallurgical coal but they exist. It needs trading platforms that facilitate participation of a wider breadth of the market. This can be done either through changes to the existing platforms, if they are willing to adapt, or looking at alternatives. Nothing boosts spot market confidence like fixed price trades and that remains the constant cry of the metallurgical coal market.

Iron ore, which does not suffer from the liquidity crisis of metallurgical coal and steel, has been on the Chinese government’s radar because of “abnormal” price movements. Talks about grand changes to how China buys iron ore have surfaced frequently this year and highlight the state’s focus on purchases of the commodity. Market participants were lukewarm to a report last week that said that a central buying group will be responsible for China’s iron ore purchases in the future. While the Chinese government’s ability to shape the future of the iron ore pricing mechanism may be exaggerated, the added scrutiny and heightened political attention affects sentiment.

The current pricing mechanism, based on indexes, has been in place for over a decade and ditching it is not a realistic short-term option. But scrutiny from the Chinese government has stoked conversations about the role of futures and the need for greater liquidity coming from participants outside the three largest mining firms, along with a larger focus on fixed price spot trade to ground prices in the physical market. Consumer demand for a “basket approach” to pricing or using multiple indexes has grown in popularity, giving market participants an index “methodology hedge” that keeps the pricing system accountable.

Volatility is a function of market conditions that are often outside the participants’ control. But some of the problems facing the steel and raw materials markets are self-inflicted as a result of inertia. Steel markets are clearly too volatile to manage fixed price term contracts and long lead times. It is time to look at indexes. But as the markets using indexes show, index-based systems too need consideration, support and maintenance to be as effective as they can be.

For regular updates on the ferrous markets, find out more about our Argus Ferrous Markets service here.

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