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China's iron ore futures may finally give it pricing benchmark

Manolo Serapio Jr and Silvia Antonioli
Monday, 18 Nov 2013 | 2:15 AM ET

SINGAPORE/LONDON, Nov xx (Reuters) - China is making its third attempt in two years to have a bigger say in pricing iron ore. This time it may have hit on the winning formula.

Brisk trade in the first month on Dalian iron ore futures brings Beijing a big step closer to its goal of a China-based pricing benchmark for the world's second most traded commodity after oil, and the biggest earner for top miners Vale , Rio Tinto and BHP Billiton .

China, the world's biggest buyer of a raft of raw materials from copper to coal, is pushing hard to establish pricing benchmarks for commodities.

Iron ore is China's largest import commodity by volume and, spending nearly $100 billion annually, it wants to be sure it pays a fair price. The government has in the past accused the big miners of delaying shipments and holding back stocks to pump up indexes published by data providers like Platts, used as benchmarks to price cargoes..

The Dalian contracts are the world's only iron ore futures backed by physical delivery, giving China a first move advantage it doesn't have with grains or metals. If the government allows foreigners to trade derivatives in the Shanghai Free Trade Zone, this would clear a major hurdle that held up previous attempts to set a benchmark.

"If more customers use the Dalian futures, why would anyone use Platts?" Li Xinchuang, deputy secretary general of the China Iron and Steel Association, told Reuters.

"(Platts) can't represent consumers' interest as it represents more of the interest of producers."

Platts, a unit of McGraw-Hill Financial, said its pricing process is transparent.

Volume on the most-active May contract at the Dalian Commodity Exchange reached more than 121 million tonnes since its Oct. 18 launch. That was nearly seven times the total volume of derivative swaps that top global clearer Singapore Exchange handled in all of October.

"I think this is massive for the market and will likely change the way iron ore is priced," said a trader at a major commodity trading house that has exposure in both the physical and swaps markets.

"We will see the physical prices come closer to the futures prices and then the indices will die down in a couple of years."

Drawn by brisk volumes in Dalian, a mid-size Chinese trading company cut its exposure to over-the-counter swaps by half to invest the funds into Dalian iron ore futures, a manager at the Shanghai-based firm said.

Beijing has been trying to create an iron ore benchmark since the industry three years ago shifted to spot rates, after 40 years of fixing contract prices annually. It created its own price index in 2011 and then a physical trading platform last year.

China-based futures can thrive on domestic hedging demand. But to really become a global benchmark the sellers need to be involved, especially the major Australian miners who supply the bulk of the country's ore, and it's not clear this will be the case.

Rio Tinto does not plan to trade Dalian iron ore futures, chief executive Sam Walsh said, citing company policy toward financial derivatives in general.

BHP Billiton declined to comment when contacted by Reuters but said it provided feedback to the Dalian exchange regarding specification and physical delivery aspects of the futures contract.

Probably the biggest hurdle is the limits on foreign firms trading Chinese derivatives, and it is the potential changes to this restriction in the Shanghai Free Trade Zone that traders will be watching closely.

"Right now, benchmarks are based where the industry started but what is required are new rules which could be set up in the Shanghai free zone," said Marco Dunand, chief executive of global trader Mercuria.

"That could transform the sector entirely." ($1 = 6.0968 Chinese yuan)

(Additional reporting by Maytaal Angel and Ron Bousso in LONDON, Sonali Paul in MELBOURNE, Ruby Lian in SHANGHAI and Florence Tan in SINGAPORE; Editing by Michael Urquhart)