The Importance of Iron Ore Derivatives

How iron ore derivatives will change iron ore mining

The global market in iron ore derivatives is growing rapidly and receiving increased attention from various sides of the mining industry. Derivatives trading has changed the coal industry and the gold industry, will it do the same to the iron ore industry? What should an iron ore miner know about iron ore derivatives?

To start with the basics: An iron ore derivative is a financial way to invest in iron ore without actually owning the physical ore. Traders can choose to buy or sell ore or bet on future price developments by trading iron ore swaps and options. Deutsche Bank launched the first iron ore swaps in 2008, basically enabling customers to fix the iron ore price for some time at a small fee. Other institutions have followed, as the derivatives market has been boosted by the change from annual benchmark pricing agreements between the large miners and Asian steel producers to quarterly pricing. The size of the market has more than doubled each year since 2008 and is expected to reach over 20Mt in 2012 and up to 60Mt in 2013. At this point the derivatives market will measure roughly one third of the size of the actual physical iron ore market, and the end of its growth is certainly not yet in sight. As ‘liquidity’, or activity in the market, is a key word for many investment professionals to enter into trading, the growth of derivative trading will be self-enforcing for some time.

The obvious users of iron ore derivatives are the actual sellers and buyers of iron ore: miners and steelmakers. Derivatives enable those parties to lock in a price of iron ore for up to four years: in this way a miner can get a guaranteed income for (at least part of) production, and a steelmaker does not have to worry about price of inputs for that period. However, a large group of traders are purely financial investors, trying to gain exposure to iron ore prices and the drivers of price developments — most notably, the growth of China’s economy. There is no direct way to invest in the growth of China, but putting your money in iron ore gets you quite close.

Now why should a miner care about this market? For most miners the sales of the product is something done by a group of strange people in the marketing department, who don’t know a thing about mining but who appear to know how and when to sell the product. However, the introduction of derivatives will change the actual mining work for iron ore miners in three ways.

Firstly, miners that are willing to lock in iron ore prices are able to invest in high-risk short-term projects, for which the uncertain margin would pose too big a risk without the price guarantee that can be achieved by hedging using derivatives. Smaller players will benefit especially from this stability.

Secondly, as demonstrated in other commodity markets that have seen the introduction of derivatives, iron ore derivatives will increase the volatility of iron ore prices, making executives wary of investing in long-term projects. While derivatives can give micro-stability for certain projects, they also drive macro-volatility.

Thirdly, diversification will become more important. In a world with well-functioning derivatives there is no stock price premium for any type of miner. If an investor wants to invest in iron ore, he will buy an iron ore derivative. If the investor wants higher leverage to the price, he will use iron ore options for that goal. Investing in an iron ore miner to get exposure to iron ore is no longer necessary. Unlike miners’ shares, derivatives don’t have unwanted side effects like exposure to CEO’s mistakes or governments who want to make a point by not giving a much-needed license. Investors in mining shares invest in the ability to generate returns by good management; they no longer invest mainly to diversify their portfolio. As a result, miners are driven to pick the best mining projects available to them, whatever the product of that project may be.

Iron ore derivatives will change iron ore miners by slowly making them more diversified, more risk-averse, but able to take on higher-risk short term projects.

Still, this change is nothing like the impact gold exchange traded funds (ETFs) have had in the gold mining space, because iron ore does not compare to gold as an investment class. Investors love investing in gold because it enables them to diversify their portfolio. Iron ore is much more dependent on the general health of the economy, making the price of iron ore track the stock market much closer than that of the gold price. Consequently iron ore derivatives will never be as important to iron ore mining as gold derivatives are to gold mining. Still, iron ore miners can’t allow themselves to ignore the iron ore derivatives market.

Wilfred Visser is the author of theBusinessofMining.com, a mining business blog bringing together the technical and the business sides of the mining industry.

He works in the M&A group of a mining company included in the S&P500. Wilfred holds both a MSc. Mining Engineering from Delft University of Technology and an MBA degree from a top tier business school.

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