BHP Makes History

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Greg Peel

It began with coking coal price negotiations between BHP Billiton ((BHP)) and Japanese steel makers earlier in the month, and as FNArena posited in Big Win For BHP Coal, Iron Ore Next, speculation was that an upheaval was also imminent in iron ore price negotiations.

After five years of trying, BHP has won.

Yesterday BHP announced it had reached agreements with a significant number of Asian iron ore customers to sell its iron ore on a quarterly basis only, and for a “landed” price. This means BHP had achieved two major breakthroughs in one, both of which represent the company's long held desire to sell iron ore at prices closer to spot prices rather than via annual fixed-price contracts.

As explained in the article cited above, the entry of China as a net iron ore importer into the market, along with India as an exporter, and joining the established importers in Japan and South Korea, and the major exporter Brazil, and various other smaller import/export players across the globe, has meant that the iron ore spot market has become a significant driver of price. When benchmark annual contract pricing was established half a century ago between Australian producers and Japan, the spot market was virtually non-existent and used only in “emergencies”.

Contract pricing disadvantages the producer, given it is the producer who loses out both through production delays and through failures of buyers to make good on contract volumes. But when Australian iron ore and coal producers were first trying to woo Japan as a buyer decades ago, they were prepared to make concessions. When China came storming into the market, it expected the same concessions.

One of those concessions, aside from annual benchmark pricing, was freight cost. In short, Australia agreed to bear the freight cost within the pricing schedule such that it sold its ore “freight on board” (FOB). When Brazil joined as a seaborne exporter, it complained that the greater distance of travel meant it would be disadvantaged on an FOB price, so Brazil was granted contracts at a “cost, insurance and freight” (CIF) price, or what is best known as a “landed” price.

It's a little bit more complex than that in actual fact, but let's stick with the simple version. One way of looking at it is that Brazil's Vale sold iron ore to China in Brazil while BHP sold iron ore to China in China. Vale didn't have to pick up the freight bill, but BHP did. Prices came in for some adjustment, but not to the full amount of the difference.

This freight differential is one thing BHP has been fighting about years, long before it started trying to push for spot pricing. The only way it was ever going to win, however, was for rival Rio Tinto ((RIO)) to join forces. Finally, two years ago Rio did come to the party to create necessary leverage, and last year some concessions were made, albeit not to the full amount of the difference. But Vale could see where this was heading.

Having won the support of Rio, BHP's next step was to force its customers to abandon annual contract pricing. Volatility of supply and demand has been sending the spot price way, way over the annual price over the past year or more and BHP was not going to take its disadvantage lying down. Last year, however, the GFC forced the annual contract price down some 44% with Japan. China held out for a bigger price concession. BHP baulked, China wouldn't budge, and in the end no deal was struck. The move backfired on China, which ended up buying most of its iron ore at the Japanese price anyway in the interim and also excess volumes at spot. Indeed, strong demand from China is what has pushed the spot price up, and up, and up in the period.

Over the past twelve months BHP sold two-thirds of its iron ore at annual pricing and one third at spot.

As I noted, Vale could see where all this was heading for the 2010 negotiations. Preempting its Australian rivals, Vale suddenly announced it would sell only on quarterly contracts and only at a price which more closely represented the spot price, or at that stage a 114% increase over last year's Japanese contract price. BHP would have popped the champagne that night, given Vale was now effectively onside. The crack was opening up in the benchmark system, and BHP intended to drive a bulk carrier right through to the centre.

The pricing agreement BHP has now reached with Asian customers is summed up as one of a “market clearing” price. What price “clears” a market of outstanding demand and supply? A spot price. And for pricing equality's sake, a “landed” price, meaning all producers are working off the same benchmark. The one concession to pure spot pricing is the fact that prices will be good for three months. This is, after all, a major seaborne market, so some concessions need to be made on timing of production and sale.

So the two breakthroughs of which I spoke earlier are the end of annual pricing and the end of the freight differential which are, both jointly and severably, history making in their significance.

To put this into perspective, BHP should be looking at a possible 100% price increase to US$120/t. However, the initial price rise will not be so great given BHP is graciously allowing a “transition phase” under a sort of arrears pricing system, in which the previous quarter's price will be used to set the current quarter price. But over time BHP will move the “current quarter” price to spot.

As such, resource analysts are not yet quite sure at what price the first of these quarterly contracts will be set. But for most, this news has provided sufficient confirmation to now lift expectations above earlier 60-70% conservative estimates. And spot is still much higher at US$150/t presently.

This has meant a rush to reset earnings expectations for BHP, Rio and other Australian producers, the magnitudes of which are dependent upon where analysts had previously set their forecasts. But as delighted as all analysts are with BHP's breakthrough, the new system actually ushers in a complication – analysts use one-year average price forecasts in their valuation models.

So now analysts have the task of trying to forecast just how each quarter's contract price might translate into a yearly average. Can spot iron ore prices just keep going up? JP Morgan, for one, doesn't think so. The JPM analysts have set a 65% annual average price increase as their forecast given they assume the iron ore market to be currently overheated. Therefore the first price might look fantastic, but subsequent prices perhaps not quite as fantastic.

Most other analysts have satisfied themselves with simply speculating for now, until more detail is forthcoming. This mostly involves plugging in yearly numbers which hold a 100% or so price rise steady, and watching what earnings increases fall out the bottom.

Suffice to say, they are significant. For the common or garden investor, it must be appreciated that yesterday's announcement did not come out of the blue. There is a lot of positive expectation already built into the prices of BHP, Rio and others.

Stay tuned for more news.

In the meantime, note that BA-Merryll Lynch is the most recent broker to point out that steel prices have been rising recently in line with raw material prices.

The fear is that the recovery in global steel demand could quickly be scuppered by extreme increases in the costs of steel making raw materials – coal and iron ore. Margins in the steel game are tight. But the evidence suggests to date that demand destruction is not occurring, and that steel producers are so far be able to pass on raw material price increases into steel price increases without dangerous margin pressure.

Of Australia's two major steel producers, OneSteel ((OST)) also produces its own iron ore but Bluescope ((BSL)) does not. Merrills has Bluescope on a Buy rating, assuming equivalent steel price increases, but Neutral on OneSteel given its share price has already been running.

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