Emerging Arbitrage? Iron Ore Swaps vs. Ore Producers

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.

How? Well essentially if these companies' market valuation becomes heavily dependent on future iron ore prices, one might be able to hedge exposure via iron ore swaps and perhaps capture a strong return with less risk. Say iron ore producers' market prices have fallen due to concerns of falling iron ore prices. If one could hedge the fall in iron ore prices using a derivative, and buy the underlying iron ore producers, there might be good return with manageable risk. (If iron ore prices fall and stock prices fall, if you got good pricing, you could still earn a net posotive return if your short derivatives position does well)

Can I see a current opportunity right now? No, I'm just exploring the idea. But it's definitely worth thinking about given that to some extent it's rather unmined territory. No pun intended. You can get up to 24-months hedging via the FSI swaps, for more on their ore contract go here. Of course there are now other companies such as major financial firms providing iron ore derivatives trading as well. Unfortunately I am currently not blessed with a Bloomberg, so can't provide direction on data they likely provide.

FIS has teamed up with the London Clearing House to offer the FIS Iron Ore Swap. The cleared CIF China contract is designed to enable better price risk management for users and traders and eliminate counterparty risk, thus managing financial exposure.

Already the leading freight derivatives and fertilizer swap broker, FIS is the only independent brokerage for iron ore swaps, producing the only independent forward curve as well as daily market information, comment and price history. FIS is relied upon to supply its daily mark-to-market assessment to clearing houses LCH.Clearnet and SGX Singapore.

The cleared iron ore derivative contract operates as an over-the-counter, cash-settled agreement, with settlement against The Steel Index TSI. Trades can also be settled bilaterally against the Metal Bulletin MBIO or Platts Iron Ore Index and these trades will generally operate under an international swaps and derivatives association agreement. Trades can be made on a per month, per quarter or per calendar year basis and prices quoted up to 24 months forward.