A new opportunity? 58%-Fe iron ore derivatives primer

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1 28 October 2014 A new opportunity? 58%-Fe iron ore derivatives primer Executive summary Increased iron ore supply driven by Australian producers has increased the proportion of low-grade production to 46% of the country s total production. The decoupling of prices between the benchmark 62%-Fe grade and 58%-Fe grade products has increased exposure to basis risk Mining companies, traders and steel mills are looking for a 58%-Fe price risk management tool Iron ore market update Seaborne iron ore supply has increased significantly this year. The Big Four producers, Brazil s Vale and Australia s Rio Tinto, BHP Billiton and Fortescue Metals Group, have together increased iron ore production by 12% year-on-year from a combined 223m tonnes per quarter in Apr-Jun 2013 to a combined 250m tonnes per quarter in Apr-Jun The growth in supply has been driven by two factors: Increased demand from Asia, specifically China where imports continue apace despite relatively lacklustre real end-user demand for steel products. China s port iron ore inventories have swelled to above 110m tonnes this year, an increase of 28% year-on-year for Jan-Aug The major producers are seeking to increase their share of the seaborne iron ore market from 67% to more than 70%, driven by their comparative low production costs. Higher cost competitors, both in China and internationally meanwhile, are struggling to maintain positive production margins. The scale of the growth driven by the big three Australian operators can be seen from the fact that Rio, BHP and FMG have increased production by 17% in Apr-Jun 2014 year-on-year, while Vale has managed to increase production by just 2% over the same period year-on-year. The near-term picture looks even less encouraging for Vale with Brazilian exports of iron ore to China in August at just 14.7m tonnes, down 12% year-on-year and down 9% month-on-month. Exports to Japan were also down 6% year-on-year. The change is significant as Vale remains the world s primary producer of high-grade ore and thus any decline in Asia market-share for Vale results in a lowering of the average quality of ore available to the market. Official Chinese import data for July show that Brazil s share of Chinese iron ore imports was 17%, down from 22% in December 2013, while Australia s share increased from 51% to 61% over the same period.

2 The opportunity Just as the increase in Australian production volume is behind the increase in overall iron ore supply, so the majority of the new volume hitting the market is low-grade iron ore. Generally speaking, iron ore with an iron (Fe) content of better than 60.00% is considered high-grade and iron ore with an iron (Fe) content of worse than 60.00% is considered low-grade. Iron ore deposits decline in quality over time. When first identified, the better quality product is exploited first, meaning projects extracting previously over-looked deposits tend to produce lower grade ore. For example, FMG is the fastest-growing iron ore producer in the world in both absolute and percentage terms but only produces low-grade iron ore. Established producers such as Rio and BHP are also seeing their assets decline in quality over time in a process known as degradation. Approximately 30% of the iron ore produced by Rio Tinto and approximately 27% produced by BHP is now sub-60%-fe and considered low-grade. Market practice since the breakdown of the annually-negotiated iron ore price benchmark in 2010 has been to price low-grade ore from the high-grade 62%-Fe spot benchmark. However, the average correlation between the 62%-Fe spot (TSI) and 58%-Fe, low Alumina spot (TSI) price has collapsed from the 2013 average of 98% to an average of 89% since July 2014 as the iron ore market price has fallen and low-grade supply has increased. Regular renegotiations of quality discounts to the 62%-Fe benchmark are putting stress on trading relationships. The proposition From early 2015, the Singapore Exchange (SGX) will introduce (subject to regulatory approval), two separate low grade derivative contracts for cash-settled Iron Ore CFR China (58%-FE Fines) derivatives settled against two different iron ore indices: The Steel Index (TSI): TSI 58% Fe, Low Alumina Fines Metal Bulletin (MB): (MBIOI 58) + (MBIOI 58P (High Specification)) The Steel Index As of 1 st July 2014, The Steel Index (TSI) has published a 58%-Fe, low Alumina iron ore fines reference price to reflect the increased relevance to the market of high loss-on-ignition (LOI), low impurity iron ore with an iron content of between 56.00%-Fe and 59.00%-Fe. The pre-existing 58%-Fe content index was conceived in 2007 when low-grade Indian iron ore formed the back-bone of the spot market for low-grade material.

3 Index Specification - TSI TSI 58%-Fe, low Alumina, reference price specification and a sample of assessable Australian material Product Fe Si02 Al203 S P H20 LOI Annual Volume 58%-Fe, 1.5%-Al TSI Permissible TSI Max Max Max Max Max Min HIY RTIO m t Robe Valley Fines RTIO m t RTX Fines* RTIO N/A N/A N/A 5.00 Adhoc Yandi fines BHPB m t Jingbao Fines (1) BHPB Adhoc * Jingbao Fines (2) BHPB Adhoc * Fortescue Blend FMG m Fines Kings Fines FMG m t Super Special FMG m t Fines Rocket Fines FMG m t Atlas Standard Atlas m t Fines PPCS PMI m t Total 308m t * Products not index permissible

4 Index Specification - Metal Bulletin The aggregate of the MBIOI -58 and MBIOI 58P indices are used by the majority of market participants to price long-term contract and index-linked spot tonnage for the 60m tonnes of Yandi Fines produced every year. MBIOI 58 represents higher impurity low-grade material and reflects Indian ores that previously formed the backbone of the low grade spot market. MBIOI 58P represents lower impurity low-grade material and reflects the premium Australian ores command over ores of Indian origin. MBIOI 58/MBIOI 58P MBIOI - 58 MBIOI - 58P (High Specification) Price US$ per dry metric tonne, CFR China US$ per dry metric tonne, CFR China Material Origin All Origins All Origins Fe Content Base 58% 58% Fe Content Range 56% to 60% 56% to 60% Silica Base 5.50% 5.50% Silica Max 9.00% 9.00% Alumina Base 3.50% 1.50% Alumina Max 5.00% 5.00% Phosphorus Base 0.08% 0.05% Phosphorus Max 0.15% 0.15% Sulphur Base 0.04% 0.01% Sulphur Max 0.07% 0.07% Moisture Base 8.00% 8.00% Moisture Max 10.00% 10.00% Granularity Base >90% <6.3mm >90% <6.3mm Granularity Min at least 90% <10.0mm at least 90% <10.0mm Granularity Max at most 40% >90% <10.0mm at most 40% >90% <10.0mm Trade Size Minimum 30,000 tonnes Minimum 30,000 tonnes Payment Terms Payment at sight Payment at sight Delivery Port Base Qingdao Base Qingdao Delivery Period Within 8 weeks Within 8 weeks Publication Daily at 7 pm Singapore time Daily at 7 pm Singapore time (NB: The differences to Alumina, Phosphorus and Sulphur base between MBIOI 58 and MBIOI 58P)

5 Conclusions Low grade, not second best Increased iron ore supply, driven by the expansion of Australian production, has increased the proportion of seaborne iron ore that can be considered low-grade. Market practice since the breakdown of the annually negotiated iron ore price benchmark in 2010, has been to price Rio Tinto s Hamersley Iron Yandicoogina (HIY) Fines and FMG s Fortescue Blend Fines and Super Special Fines from the high-grade 62%-Fe spot benchmark. However, the decline in the iron ore price has caused the average correlation between 62%-Fe spot (TSI) and 58%-Fe, low Alumina spot (TSI) price to collapse from the 2013 average of 98% to an average of 89% in the four months from July (see chart above). Regular renegotiations of quality discounts to the 62%-Fe benchmark are putting stress on trading relationships and differences between quality discounts applied to contract tonnes and quality discounts applied to spot tonnes are creating basis risk. However new tools are available to hedge and trade low grade iron ore. From 1 st July 2014, The Steel Index (TSI) has published a 58%-Fe, low Alumina iron ore fines reference price to reflect the increased relevance to the market of high loss on ignition (LOI), low impurity iron ore with an iron content of between 56.00%-Fe and 59.00%-Fe content. The aggregate of the MBIOI -58 and MBIOI 58P indices are used by the majority of market participants to price long-term contract and index-linked spot tonnes for BHP Billiton s Yandi Fines. SGX, already the hub for 62%-FE iron ore derivatives will list the two new 58%-FE grade contracts from early 2015, enabling trading of cleared, cash-settled derivatives. FIS already works with the sector s biggest mining companies, traders and steel mills in the 62%-Fe iron ore market, providing risk management and hedging through the use of iron ore swaps and futures. With these same counterparts now increasingly exposed to basis risk and in need of a suitable mechanism with which to hedge 58%-Fe material, we are seeking your views and feedback on how you see a low grade derivatives market emerging and how FIS can support that evolution. For further information and to discuss trading opportunities, please contact: Rory MacDonald on Tel: rorym@freightinvestor.com

6 About FIS FIS is a leading provider of impartial and accurate risk management advice to customers in freight, ferrous, iron ore, fertilizer and fuel oil derivative markets and also provides physical shipping and cargo services. Founded in 2002, FIS has enjoyed sustained growth in each year of its operation and has expanded via its network of trading associates and branch offices to offer coverage in the United States, UK, Dubai, India, South Korea, Singapore and China. The company is registered and regulated by the Financial Conduct Authority (FCA) in UK. Disclaimer This document is made available for general information purposes only and does not constitute investment advice or an offer, or solicitation of an offer, to buy or sell any securities, commodities, derivatives or any other financial product. While every effort has been made to verify the accuracy of the information appearing in this document no representation or warranty is made as to its validity, timeliness, completeness, accuracy or reliability and it should not be relied upon as such. All information is subject to change without notice at any time and markets can be subject to rapid, unexpected movements. All information contained in this document is indicative only and may not be suitable for valuing positions. No liability whatsoever will be accepted for any direct, indirect or consequential loss arising from any use of the information contained in this document or any omission from this document. This document is directed at Market Counterparties and Intermediate Customers as defined by the FCA. This document is not for distribution to nor should it be relied upon by Private Customers as defined by the FCA. This document is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to any applicable law or regulation. FIS is registered and regulated by the Financial Conduct Authority (FCA) in the UK.