VALE

The iron ore market has been going through some pretty intense growing pains, exemplified by contentious negotiations between companies such as Vale(VALE)/Rio Tinto(RTP)/BHP(BHP) and chinese steel producers, and the actual dentention of some BHP employees by Chinese authorities, on spying charges. More on the sector here.

Nevertheless, it is developing in fits and spurts, away from long term fixed contracts and more towards shorter term market-based repricing. One force in this trend has been the development of iron ore swaps by UK-based shipping broker FIS. Most recently, SteelGuru reported that FIS had broked its first China Iron Ore swaps, aimed at breaking the traditional fixed-price negotiation system which recently has been causing so many problems.

“We are pleased to trade the first ever LCH.Clearnet iron ore swap. We believe that given the rapidly changing iron ore market, more companies will phase out their use of the benchmark price and trade spot, driving the greater use of risk management with derivatives. With only 15% of the 2009 iron ore requirement fixed so far, we are urging the China Iron and Steel Association to scrap the benchmark and embrace greater spot fixing.”

While an early pioneer, FIS is not alone either. Credit Suisse and Deutsche bank set up iron ore swaps last year, and more have joined since.

Obviously this nascent derivatives market has a lot of good uses for industry players. But I think it could open up some interesting potential arbitrage opportunities for institutional investors as well. Any nascent market, especially if difficult to access and with relatively low liquidity, plus volatile pricing swings, is bound to have inefficiencies. For example, going forward an interesting trade to watch would be pricing between iron ore swaps and the stock prices for major iron ore producers such as CVRD, Rio, BHP mentioned above. Something similar might be possible for bulk shipping companies as well.