Iron Ore futures, derivatives trade soars to new heights as spot price plunges

UNITED KINGDOM October 07 2014 6:01 PM

LONDON (Scrap Register): The recent and precipitous collapse in spot iron ore prices appears to have prompted a renewed surge in the trade of iron ore swaps, options and futures in September, with cleared volumes climbing to a fresh record during the month, said The Steel Index.

In total over 62 million tonnes of futures and derivatives were cleared across exchanges outside China in September, of which options made up 15.6 million tonnes and futures 25 million tonnes. The rest comprised swaps. As well as being an overall record for US$-denominated iron ore derivatives, September marked the highest-ever volume for options, and also futures, which for the first time eclipsed swaps in volume.

According to TSI, options can serve as a useful tool for those holding physical cargo to protect themselves against further downside (or upside in the case of buyers) without sacrificing potential gains by paying a premium, effectively serving as an insurance policy. The rising use of futures has meanwhile been driven largely by regulatory pressure, which has led a larger number of companies to favour these over swaps. In practice, swaps and futures contracts on SGX are mutually fungible.

The last peak in derivatives trading was in June this year, when nearly 57 million tonnes of derivatives were cleared through Singapore Exchange (SGX) and the Chicago Mercantile Exchange Group (CME Group) combined. July and August saw traded volumes recede as spot prices for 62% Fe iron ore fines, as measured by the TSI 62% Fe benchmark, retreated to a (relatively) tight range of around US$10/dmt between US$90-100/dry metric tonne on a CFR Tianjin basis. The slump in prices to below US$90/dmt towards the end of August was enough to trigger a fresh bout of frenetic trading as market participants sought to protect themselves against losses.

From its humble beginnings back in 2009, the market for cleared iron ore derivatives has evolved into a market that is now more than half the size the entire seaborne market was in 2013, if September volumes are annualised. This equates to around three-quarters of the volume of iron ore China is expected to import this year.

The spot price of physical iron ore has continued to slide through September, caught as it is in a vicious downwards spiral of steel and raw materials prices. A fresh wave of iron ore supply and the resultant lower prices have encouraged China’s steelmakers to ramp up output, exacerbating oversupply in finished steel amid tepid demand from a struggling housing sector. Plunging steel prices in turn pressure mills’ cash flow and margins, prompting them to pull back from the iron ore market. Miners in Australia and elsewhere, which are now operating on tighter, if not negative margins, have also increased run-rates in a bid to lower their cost base, exacerbating oversupply.

Meanwhile, on the demand side, little of China’s recent injection of 500 billion yuan into its banking system has reached the steel sector, since steel mills and traders are among banks’ least desirable borrowers in the current economic climate. The country has seen a steady trickle of negative news stemming from the real estate sector, which has been one of the biggest drivers of steel demand over the past decades.

At the end of September, the TSI benchmark 62% Fe fines price for Chinese imports stood at US$78.50/dmt CFR Tianjin port, down more than 10% from the start of the month. The market generally takes a hiatus over the first week of October, when key customer China retires for the National Day and Golden Week holidays.

This year, the holiday has, uncharacteristically, seen some trading, with prices edging up on thin volume. This is generally believed to have been trader-driven. There remains little consensus on which direction prices will take when Chinese mills return after the holiday. Past experience tells us, however, the one thing that is certain is further price volatility can be expected.

Over 99% of all US$ denominated cleared iron ore derivative contracts are settled against the TSI benchmark 62% Fe iron ore price for fines delivered into Tianjin. This year has seen the successful iron ore contracts on SGX complemented with the launch of swaps and futures for ASEAN HRC imports and coking coal contracts for Australian exports and Chinese imports, all settled against TSI’s benchmark prices. The addition of the latter completes a “virtual” or “paper” steel mill, meaning that market participants are now able to manage risk across the whole steelmaking value chain in Asia.