As Rio Tinto (LSE:RIO, ASX:RIO) confirms it will be  joining BHP Billiton (LSE:BLT, ASX:BHP) and Vale (BSP:VALE5, NYSE:VALE) in pursuing quarterly iron ore contract negotiation, the world’s three largest iron ore producers bring a fundamental shift in the industry away from the forty year old system of annual agreements, with ramifications spanning global commodity and equity markets, the world’s major economies and individual end-consumer alike.

To assess the impact of these new quarterly negotiations we must first consider the previous system.

Traditionally, iron ore prices have been negotiated between miners and steel producers once a year, where the first deal between the two groups would act as a benchmark for the wider industry, effectively setting one price for the year. Concurrently a spot market was (and still is) in place, which although much smaller than the annual market, played a key role and in fact brought about the necessity for a fundamental change in the system.

The key problem with the annual system was the emergence of significant discrepancies between the benchmark price, negotiated once a year, and the free floating spot rate. The annual negotiations effectively locked miners into one price for twelve months, at what was deemed a ‘fair’ price at that time.

If however iron ore appreciated in value, with gains being made in the spot market, miners would be selling their product for a much lower value than it was originally priced. This forgone revenue has been a significant area of contention for many years, with major iron producers arguing for a ‘fairer’ system as with other metals markets.

Now of course this could be argued the other way round; if prices were falling (as in recent years for example) the iron miners would have locked in a higher price than the market rate. Empirically however this did not always pan out.

Steel producers would often renege on their original agreement and buy their raw materials at the spot rate, leaving their costs lower. In this way, the benefits of the ‘locked’ price were very much one sided in favour of steel producers, and allows us to see the first effect of the new quarterly agreements; increased revenue and profit for iron ore producers.

Allowing miners to negotiate iron ore contracts quarterly means the price of their product, and hence revenue and profit based on those prices, will be moving in a much more synchronized fashion with the floating market rate.

They will no longer be bound to a price set when market conditions were different, and instead will be able to renegotiate their contracts based on prevailing market conditions. With metals prices climbing steadily across the board as the global economy emerges from recession and begins its recovery, miners will now be in a position to take advantage of the increasing prices for their product. Although specific details surrounding the individual negotiations are somewhat limited, we can take negotiation with Japanese steel makers as an example. The Brazilian miner negotiated a 90% year on year increase in prices with Japanese steel makers, agreeing to a price of between $100 and $110 per tonne of iron ore for the quarter starting April 1st.

With demand for iron likely to remain stable despite this price rise, particularly as industrial production ramps up as economies bounce back, miners are set to reap the benefits of the new methodology in this year’s bottom line.

The Financial Times (FT) for example reported one executive, who estimated the individual benefit of these new prices for Rio Tinto, BHP Billiton and Vale, would be a $5bln each in this year alone. At this stage it is worth noting however that although agreements have been made with most Asian countries, China as yet is still insisting on annual agreements.

Although negotiations are ongoing between the three largest iron miners and Chinese steel producers, a move to quarterly agreements with the number one global steel producer, would undoubtedly strengthen the benefits of the new system as far as iron producers are concerned.

As beneficial as these price increases are for miners, inevitably they will have the opposite effect for those who are paying them, i.e. steel producers. The new system will mean steel producers are paying higher prices for iron ore, at least when markets are rising, than would have been the case under annual agreements.

Some analysts have in fact estimated that steel prices may rise by as much as a third as these quarterly negotiations begin to take hold. Although this will increase their costs and lower profits, it is expected most of the increase will in fact be passed along to the end consumer, with steel prices likely to rise in line with iron ore. 

This increase is itself another key effect of the new contract negotiations. Increasing the cost of steel will eventually filter through to prices of all end products for which it is a raw material. In car production for example, steel is one of the main costs of production as far as raw materials are concerned.

Any significant increase in steel prices will raise costs for auto makers, and eventually raise the price of cars for the end consumer. Aside from the obvious problems this causes those at the end of the production chain, both for those selling steel and those producing goods that depend significantly on steel, the impact on the broader economy may in fact be much more widespread.

With the global economic recovery still in what many would class as a ‘fragile’ stage, this sharp, quick switch and the subsequent revenue changes for some of the world’s largest companies, may place sustained growth at risk. On a simplistic level, one could argue that the loss in revenue to steel producers would be offset by that gained in iron ore mining. However the increase in prices through the production chain, may hinder one of the key drivers of economic recovery, as end product price hikes reduce consumer demand.

If we take car production as an example, this sector has been one of the worst hit during this recent recession, as is natural for a high end product such as cars, in times of economic contraction. The recovery in this sector is still seen lagging somewhat across the US, Asia and Europe. If car prices were to suddenly jump because of an increase in raw material prices, demand may falter and the fledgling recovery would be at risk.

Looking from a broader perspective, an increase in raw material costs and the resulting rise in prices is itself placing inflationary pressure on an economy.

The full implications of this go far beyond the scope of this article, but suffice to say the potential to hurt the economy comes as a direct consequence, as well as the broader domino effects spanning almost every market.

It should be noted however that the use of a more fluid pricing system, for the most part, will just hasten price changes that would have come through eventually anyway. A consistent rise in iron ore prices, such as the one seen during the recent economic recovery, would have eventually come through at the annual price fixing under the previous system.

The new quarterly negotiations simply bring this move forward, although will add some volatility as they feel the impact of more short-term price swings.

One final thing to consider when looking at possible implications of these recent moves in the iron ore market, is the potential for it to lead to a more complex and liquid derivatives market, mirroring other exchange traded base metals around the world.

Historically, there have been several examples of commodities which were predominantly fixed price, moving to more flexible pricing linked to a spot rate and eventually leading to the formation of complex derivatives contracts.

The crude oil market during the late 1970’s for example underwent a similar transformation in pricing, and now the crude oil market has one of the most highly traded, globally significant derivative markets across asset classes. 

The aluminum market in the early 1980’s is another example where the emergence of flexible pricing, allowed a strong derivatives market to form, with all the benefits and costs that brings. Again the full implications of a developed derivatives market go far beyond the scope of this article, spanning from the ability of producers and consumers to hedge against risk, the increased global liquidity in the market and the increased price volatility it, along with speculators, will bring.

As highlighted at the beginning, the full extent of these implications and the time frame we will see them over, is not certain. 

However, one can be certain that these moves, many years in the coming, represent a fundamental shift for the iron ore market, the ramifications of which are likely to be felt for decades to come. 

• [Editor:editor]