How is iron ore priced?

It may not attract as many headlines as oil, but a record 19 per cent jump in iron ore prices this week has drawn renewed attention to the key steel making ingredient, which underpins the profits of most of the world’s biggest miners.

News that a flower show in the Chinese city of Tangshan was a major driver of the spike has also raised questions about the way in which iron ore prices are calculated and published.

How was iron ore priced before 2010?

Iron ore prices have actually only been set on a daily basis for the past eight years, and are not as transparent as prices for many other industrial commodity markets.

For the 40 years before 2010, the price of iron ore was hammered out between buyers and sellers in smoke-filled rooms, on fixed one-year contracts.

That system started to break down with the rise of China and the rapid growth in the country’s steel demand, as it raced to build apartment complexes, skyscrapers and infrastructure.

Australia and Brazil, China’s traditional iron ore suppliers, struggled to keep up with the voracious appetite, so Chinese steel mills started to secure material from neighbouring India. These deals were done on an ad hoc basis, which led to the creation of the first spot price indices.

Starting in 2008, companies such as The Steel Index started to compile spot prices for traders, producers and consumers. Chinese mills soon realised that some of the year-long contracts they had set with the miners were higher than the spot prices. That led some companies to default on the year-long contracts when prices plummeted during the financial crisis.

Relations between China and global miners reached their nadir in 2010 when Stern Hu, formerly Rio Tinto’s top iron ore salesman in China, and three colleagues were convicted of taking bribes from steelmakers. They were also accused of stealing “secret” information that apparently included insights into the Chinese steel industry’s negotiating position during iron ore pricing talks.

So how is the current iron ore price worked out?

From April 2010 miners moved their steel mill clients on to shorter index-linked contracts. Initially based on quarterly prices, China now buys its iron ore based on monthly average prices.

These are based on the daily prices set by price assessment agencies such as The Steel Index, which was acquired by Platts in 2011, and Metal Bulletin.

The Steel Index receives prices of physical iron ore trades from companies buying or selling iron ore, takes out the high and low outliers, standardises the different traded products and comes up with a volume-weighted average daily reference price. This comes out at 11am UK time every day.

Iron ore is also traded on futures markets on China’s Dalian Commodity Exchange as well as the Singapore Exchange.

Volumes on the Dalian exchange have risen from about 100,000 lots a day in 2013 to its current level of between 4m and 6m lots a day, according to Investec. Each lot represents 100 tonnes of iron ore.

While the volumes are large, the exchange is mainly confined to China-based traders and steel mills, because of China’s controls on capital. The relatively lower level of open interest, or the amount of outstanding futures contracts, also suggests many traders buy and sell their contracts within the same day.

Outside China, the Singapore volumes for iron ore derivatives have also grown, and in February 123.4m tonnes were traded, compared with around 20m tonnes in early 2014.

The exchange says Asian steel mills and traders account for 32 per cent of its users. The other two-thirds of participants are largely banks, international trading houses and funds. The contracts are settled monthly against the average physical price assessed by The Steel Index.