Differentiation in Iron Ore Matters |
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Frequent Divergence in Pricing of Varieties of Iron Ore Overwhelming supply and slowing demand has seen the price of iron ore tumble 44% this year. The macro picture as reported by analysts is that the forthcoming wave of iron ore supply and deteriorating property market fundamentals in China continue to weigh down iron ore prices. While this transition is probably without precedent in the history of iron ore market, another development – frequent divergence in pricing of different varieties of iron ore - is also taking shape.
The widening price differential between iron ore Fe Fines 62% and 58% CFR China was especially significant in June 2014 when the iron ore 58% price was trading at around US$18 per ton (compared to the 6-month average of about US$12 per ton) discount to the 62% price. The contributing factors to this significant price differential were the rise in supply of lower grade iron ore from FMG and other Australian producers, declining iron ore grades of Chinese production and increased pressure by steel mills to be more environmentally friendly. The combination of these factors led to relatively higher demand for better quality iron ore by steel mills.
Historically, the volatility of the price differential was anything less than a roller-coaster ride. Spread volatility surged above 20% in a number of occasions due to changing market dynamics in the last 2 to 3 years. Recently, the volatility of the spread broke historical records at 50% in June 2014. Going forward, the supply of lower grade iron ore continues to enter the market though at a slower pace. However, the declining grades of Chinese production and environmental pressure on Chinese beneficiation plants will add on to the volatility of the price differentials.
Hedging and Spread Trading Opportunities While the purpose of hedging is to remove uncertainty in price movements, imperfect hedging may arise due to differences in settlement pricing mechanism and/or iron ore grade between the physical and futures contracts. The role of a hedger is to find the most appropriate futures contract that minimise liquidity costs and basis risks. Due to frequent price divergence of the two grades of iron ore, the use of iron ore 58% derivatives to hedge iron ore 58% exposure will further improve hedging effectiveness through reduction of basis risk. Given that both iron ore 62% and 58% are also two closely related products, there are potential inter-commodity spread trading opportunities between theses two grades of iron ore.
Launch of SGX Iron Ore 58% Fe Fines Derivatives To provide market participants with a more effective hedging instrument and trading opportunities, SGX will launch two SGX Iron Ore CFR China (58% FE Fines) derivatives contracts in early 2015, subject to regulatory approval. The respective SGX iron ore 58% swaps and futures contracts are fully fungible with the same daily and final settlement prices as well as expiry dates and have margin offset that is close to 100%. There will also be significant margin credits between SGX iron ore 58% and 62% derivatives contracts. In addition, margin offset between SGX iron ore 58% and a number of SGX’s complementary bulk commodity products such as coking coal, HRC steel and freight derivatives will be made available, resulting in greater capital efficiencies.
For further details on SGX iron ore products, please contact our team or alternatively visit our website: http://www.sgx.com/asiaclear/ironore |