Big Win For BHP Coal, Iron Ore Next?

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By Greg Peel

Let's just get one thing out of the way first, because it can be confusing. One cannot simply refer to the price of “coal” because then it is not clear if one is talking about thermal coal, metallurgical coal, coking coal, coke, or PCI coal.

The first simple categorisation is thermal coal is that which is used to fire power stations and metallurgical coal (or “met” coal) is that which is used to make steel. Steel is ostensibly carbon-hardened iron so the coal provides the carbon while iron ore provides the iron. The first step is to create “pig iron” from the two inputs before the pig iron is further processed to create steel or steel alloys.

Coking coal is your common or garden met coal, and analysts will often confuse the reader by using one or other expression to mean the same thing. Coke, on the other hand, is coking coal which has been crushed and reconstituted into a denser pellet form and is thus more expensive than coking coal. Depending on the blast furnace set-up, coke can be used alongside coking coal for a more efficient process.

An alternative to coke is pulverised coal injection (PCI) coal which as the name suggests is injected in a powdered form into a blast furnace for pig iron production. PCI technology is new on the historical time line, and thus its popularity is slowly gaining.

Yesterday BHP Billiton ((BHP)) announced it had signed a deal with an as yet unnamed Japanese steel company to sell its met coal (coking coal) at US$200/t for the period of the second quarter 2010. As the analysts at BA-Merrill Lynch put it this morning, “let us be clear, the deal is outstanding for several reasons”. Merrills suggested the deal represented a “brave new world”.

So what's all the fuss?

Well firstly, the price represents a 55% jump on last year's annual contract price with the Japanese, so that's pretty wonderful news for BHP and Australia in itself. However, given the recovery of steel demand in 2009 from the depths of 2008, and resultant move up in the spot met coal price, the deal price has not much surprised analysts. It's about right. Hence any “brave new world” is not really to do with the price.

It is all to do with the contract period. For half a century, BHP, Rio Tinto ((RIO)) and other Australian coal producers have been selling met coal to Japanese steel makers on an annual contract basis. In more recent times South Korea has also moved into the market on the same basis (and always falls into line on price).

Annual contracts work as a security blanket for both buyer and seller. Given steel making is competitive across the globe, and thus margins are thin, the steel maker is comforted if he knows what his coal input price is for at least a year. And given coal mining requires significant investment, so too can the producer rest easy when he knows his sale price is fixed. Across the globe, the “bulk” minerals of coal and iron ore have traditionally traded on a one-year contract basis. The “spot” market, in which small amounts are traded at a price agreed at the time rather than any contract price, has typically been insignificant and really only there to cover times of production shortfall or excess buyer demand.

But in recent times the game has changed. Enter China, and increasingly India.

China has become the world's predominant steel producer, but is also a significant coal producer, such that China's coal needs are largely satisfied domestically. Indeed China is mostly considered a coal exporter, but occasionally it becomes a coal importer due to supply shortfalls or sudden bursts of rampant steel production. Australia does not sell coal to China on an annual contract basis.

China buys in coal to satisfy shortfalls on the spot market, and often from its neighbour India. India is a significant met coal producer, but Indian coal tends not to be as high a quality as Australian coal. This interaction between Chinese steel makers and spot coal sellers has, in recent years, meant the spot coal price has become more a significant swing indicator than previously when spot prices were clearly much higher on an emergency basis than contract prices.

The picture also changes further when one considers China is expected to continue increasing its steel production over time as a natural result of its urbanisation and industrialisation push, which includes, for example, producing cars for the first time. Barring any major new coal supply being discovered and ramped up in China, analysts expect China may become a more regular importer of coal than an exporter. At the same time, India is doing the same thing, and hence its capacity to export coal rather than use it for domestic steel production is also compromised.

The result of all of this is the coal spot market has become much more important than it ever was, and a much more robust indicator of true demand and pricing than it was previously. In earlier years, coal contract price negotiations paid little heed to the prevailing spot price given that was the “emergency” price, and hence annual contract prices tended to be a lot lower than spot. But now that the spot market has taken on far greater importance, the likes of BHP have been pushing to use the spot market as more of a benchmark, or at least an influential starting point for new contract pricing. No longer can the Japanese simply assume the contract price would be much lower than the spot price, as it always had been, as far as BHP and others are concerned.

Trading purely on spot prices and abandoning any longer term contract deals is not really a safe option either, given the volatility of the spot price. Wild swings can be sparked by such events as heavy rains in the Queensland coal fields (a very recent but also not infrequent occurrence) or heavy snow in northern China, for example. At least some price smoothing is needed, but as recent years have proven a year is a very long time in the life of commodity pricing.

In 2007 the contract prices of bulk commodities shot up significantly and in 2008 they held steady. But after mid-2008 commodity prices collapsed, such that 2009 prices were much lower. The world (and particularly China) is recovering, and so 2010 is expected to see big price jumps once more. The swings and roundabouts mean either the producer or the buyer is greatly advantaged or disadvantaged for lengthy periods when prices are fixed for one year. So if spot prices are too volatile and annual contract prices too lengthy, is there a middle ground?

Yes there is, and that is the “brave new world” of quarterly contract pricing. That's why the BHP deal is so significant, because it represents the first fundamental change in bulk commodity contract pricing since trade between Australia and Asia began. BHP has been pushing for this for a while, so that's why it has scored a big “win”.

The win does not have implications for coal alone. BHP's market of great frustration has, for the last few years, been the iron ore contract market. And the reason for the frustration has been the entry of a dominant new iron ore customer in China. China has coal, but not enough iron ore of sufficient quality to feed its huge steel-making industry. It is China's major entry into the market which has pushed up the price of iron ore, most significantly in 2007. But China doesn't like to think anyone else has all the control. While price negotiations with the Japanese and Koreans on iron ore and coal tend to be polite and swift, with Japan having been in this game for decades, China won't roll over without haggling first.

Like coal there are also different types of iron ore, but it all ends up in steel-making. The major difference lies in the iron content, or “grade” of the ore, and Australia and Brazil boast the highest grade iron ore reserves in the world. Chinese iron ore is only of a low grade.

[For more on different forms of iron ore see The Magnetite Revolution published last August.]

Another fundamental difference affecting iron ore contract pricing is the freight cost. With China importing nearly all its iron ore requirements in seaborne form, clearly there are different freight costs between Australia, Brazil and other lesser producers. Without going into too much unnecessary (and confusing) detail here, suffice to say Australian iron ore producers long ago negotiated a deal on freight (and who covers the cost) with China which was less advantageous than Brazil's Vale later negotiated, leaving BHP bitter in more recent times and causing all sorts of heated arguments between producer and buyer.

BHP was forced to put up with the difference for a long time, because Rio Tinto would not join forces to force China's hand. Without Australian solidarity, BHP could not alone call the shots. Two years ago the new Rio CEO decided to change policy and the last two price negotiations have featured BHP and Rio standing shoulder to shoulder to achieve pricing leverage over the Chinese. This move has infuriated the Chinese (just ask Stern Hu).

BHP and Rio achieved a first price concession in the 2008 negotiations, when commodity prices were still running hot. But by 2009, commodity prices had collapsed. China assumed the boot was now on the other foot, but still it was not the case. While Japan last year quietly negotiated prices at 40% or more below the previous year's price, China held out for a better deal.

In reality, China is still holding out. No annual contract price for iron ore was ever decided between the Australians and the Chinese last year. This was victory, because China started buying new record amounts of iron ore in late 2008 and into 2009 (mostly at the "Japanese" price) and has almost singularly kick-started a global economic recovery. And having done so, it now has to again face BHP and Rio to try and settle some sort of new price – a price which will be much greater than last year due to increased Chinese demand. The boot is back on the foot of the producers once more.

So how might the issue be resolved this time around? Well, suddenly a precedent has been set. After years of trying, BHP has managed to get not only Japan, but as analysts understand its customers in Europe, India and even China to agree to not annual, not spot, but quarterly contracts for met coal. Analysts now assume iron ore pricing will have to go the same way.

That means a win for BHP in coal will likely also mean a win in iron ore (and by default, a win for Rio and other producers of either commodity).

JP Morgan notes BHP went about bringing a quarterly contract price into play by first suggesting an annual contract price would need to be US$240/t for met coal, which happens to be where the spot price is currently. The concession of a US$200/t price became the teaser to establish quarterly pricing. JP Morgan analysts had themselves pencilled in a US$175/t annual price but note market consensus had been expecting more like US$220-240 given the spot market influence. So US$200 actually looks like a weak result up front, except when you consider just where the coal price might be heading.

Merrill Lynch thinks 2010 is beginning to look a lot like early 2008 in terms of coal demand and weather interruptions, in which the annual met coal contract price was US$300/t and spot traded as high as US$380/t. As such the analysts can see US$250/t later this year and even US$280/t by year-end. Given BHP is only settling for quarterly contracts, it has three more quarters in which to pick up a better price. Buyers may have baulked straight up at a US$240 annual price, but BHP might end up averaging that or better anyway.

RBS further notes that while many analysts don't expect China to need to import thermal coal for power generation in the near future, its own analysts disagree. So thermal coal, too, could come under the new price indexing system.

But the real anticipation lies in the iron ore market.

Macquarie suggests BHP's met coal settlement has set the scene for an “explosive” move in the iron ore price. As today's iron ore market has the boot firmly on the foot of the producers, Macquarie suggests the “lion's share” of the current 105% premium of the iron ore price over last year's annual contract price (with Japan) should be captured by the producers. To date, most analysts have settled on a conservative estimate in expectation of a 60% increase – up from 50% previously. But last week Japanese investment house Nomura suggested 70% and others have gone as far as offering 80% or even 90% as possible outcomes.

One reason for the excitement is comments from Brazil's iron ore powerhouse, Vale. In recent years Vale has tended to settle its iron ore annual prices first and left BHP and Rio argue over the freight differential with the Chinese later. Vale was a bit upset when the Australians finally won freight concessions two years ago, and has seemed to play the role in the past of being the easy one to deal with. But it looks like the gloves are off.

Vale sells iron ore domestically as well, and has recently told its local buyers to expect a 40% price increase in March and another 40% increase in April to bring pricing more into line with spot. UBS analysts suggests this clearly means Vale will be expecting a similar 80% price increase for its seaborne ore.

In other words, it looks like Vale is ready to play hardball the same way BHP and Rio have been doing lately, rather than playing choir boy. It was one thing for BHP and Rio to team up against the Chinese, but the thought of ye auld iron ore rivals Australia and Brazil actually getting together in a seaborne oligopoly must have the Chinese quaking in their boots.

With spot prices 105% above last year's prices, Chinese steel-makers may well be ready to beg for quarterly pricing if something like a 70% increase for the second quarter is as bad as it gets.

But not all minerals analysts are convinced that an iron ore oligopoly can simply name its price and laugh all the way to the bank. There is the small matter of the price of steel coming out at the end of all of this.

Now, steel is not just steel either. There's rolled and flat and long and tube and you name whatever else and once again freight prices play a big part. But hot rolled coil (HRC) is a bit of a benchmark, and that currently sells for something north of US$600/t. On average, steel-makers make a margin of about 10% or US$60/t, but this fluctuates depending on demand and supply. Citi analysts note that in February the Chinese margin had fallen to US$10/t.

Citi also calculates that an 80% jump in the iron ore price would require a US$127/t increase in HRC prices to stay even (and that's even before you now have to add in this met coal price increase). We are only now entering a recovery phase in the global steel market, Citi points out. We are not in a screaming bull market.

The simple risk is steel demand destruction. If the price of steel rises too high, steel fabricators either give up, go bust or look for substitutes. And if steel demand falls, so must demand for iron ore and coal fall. Our oligopoly may find itself enjoying a one-day wonder (or one or two quarters in this case). Longer term ramifications are also possible.

High seaborne iron ore prices would encourage China to meet more of its steel-making demand from local, lower grade sources, and perhaps sell lower grade steel at a lower price as compensation, Citi suggests. Higher prices generally always spark more exploration (just look at Australia in the past few years) and any success ultimately weighs on price. It is believed China spent a bit of time in late 2008 and early 2009, when spot iron ore prices were quite low, building strategic stockpiles. It was also assumed that Chinese traders were also stockpiling ore in the hope of future price rises. If that's the case, well now might be the time to cash in. What the oligopoly might gain on price it could lose on volume.

Coming back to Chinese domestic iron ore supply, China's ore tends to be low grade (around 20% or less iron) magnetite compared to Australia and Brazil's high grade (60% or more) haematite. But the higher grades of haematite are being slowly exhausted on both continents, leading to the growing popularity of iron ore pellets as a substitute.

The high grade of haematite means it needs only be roughly crushed before being thrown straight into a blast furnace, while high-grade (70% or more) pellets are made by pulverising and reconstituting magnetite before use in the furnace. This added process comes at a cost, which is why seaborne haemetite attracts a premium. But if that premium became too high?

Macquarie analysts acknowledge this fear of demand destruction if the iron ore oligopoly were to get too greedy, but dismiss it. “Recent moves by customers,” notes Macquarie, “suggests the opposite is true”. The Japanese steel mills have lately been calling for materially higher steel prices, implying there is more of a cost-push effect at work than any fear of demand destruction.

Adding in prices for 2010-11 implied by the met coal increase and an 80% iron ore increase, Macquarie suggests earnings upside over that period of 25% for BHP and 50% for Rio. And that, notes Macquarie, has not yet been factored in by the stock market.

The period 2010-11 is an important one, because the players will likely change sides at the half-time point of 2012. It is after 2012 that analysts expect significant new iron ore supply, such as that belonging to Fortescue Metals ((FMG)), to impact on the global market. Thereafter, iron ore prices should start to decline (all things being equal on the global economic front, of course).

And that brings up an important point. Macquarie points out that despite the security offered to both sides by annual contract prices, they mostly disadvantage the producer. Producers have to suffer both customers failing to perform on their contracts and their own supply disruptions (such as those related to weather). On that basis, quarterly rather than annual contracts are to the producer's advantage.

Obviously, quarterly contracts are better than annual contracts for the producer when prices are heading up, and better for the buyer when prices are heading down. One reason Australia's economy managed not to collapse into immediate recession as a result of the GFC is that it was still selling bulk minerals, at least into the first quarter 2009, at 2008's inflated prices. It would have been a very different scene if those prices had suffered from quarterly repricing.

So post 2012, will BHP be singing a different tune? It's too far off to know. In the meantime, bring on the brave new world.

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