For the past few years the first iron ore settlement of the year has been a cause for celebration among Australia’s large bulk commodity exporters.

It was the first indication of what other iron producers expected to receive in their own settlements. Moreover, up until last year the settlement augured a new record in prices and set the resource sector up for a decent rally.

Not so this year.

Australian major Rio Tinto agreed with its major customer Nippon Steel, the world’s second-largest steelmaker, last week to cut the price of fine iron ore by 33% to $A60 and lump iron ore by 44.5% to $A70. The settlement represented the first cut in the benchmark price for seven years and reflected the sharp turn in the globe’s economic fortunes.

(For the uninitiated, fine iron ore is grades with particle sizes of less than 6mm and lump ore is with particle sizes between 10mm and 40mm. The latter is more highly prized because it is easier to smelt into iron).

The share market reaction was muted. Shares in Rio Tinto, which generates about 30% of its sales from iron ore, fell 2% on the day of the announcement while shares in its chief rival BHP, which generates around 16% of sales, from iron ore rose 2%. Both have suffered heavily from the economic slowdown.

In contrast, excitement over the iron ore negotiations last year was one of the key reasons both companies soared to their peak just shortly before the contracts were struck.

However, it could have been much worse.
China, Australia’s major customer, has been campaigning for a cut of as much as 45% in fine grades, reflecting prices that have prevailed in the spot market. And even after the announcement of the Rio Tinto deal, its producers were apparently lobbying other producers not to follow suit.

According to Dow Jones for instance, the Chinese Iron and Steel Association put out a report on its website rounding up a string of unnamed steel executives declaring they wanted more.
In any other industry a near 50% cut to the price of one’s products would be catastrophic. But if one had asked an iron ore miner a decade ago what they thought of $A60 a tonne for fine grades and one would have been met with incredulity.
The prices negotiated by Rio still represent the second highest prices on record and at this level most of the Australian industry remains profitable, with the vast majority breaking even at between $A15 and $A30 a tonne.

Decoupling (the idea that growth in China as well as Brazil, Russia and India would offset the economic growth in the developed economies) is a concept now rarely discussed in fashionable company.

However, it is in evidence on a much smaller scale in Australia. China’s $US586 billion stimulus package is directed heavily at resource intensive projects such as railways, electricity networks, and energy supply and generation.

Australian iron ore producers, despite the international economic turmoil, remain in a sweet spot. China’s domestic producers cannot compete with the highly efficient Australian industry. As a result the country imports three-quarters of its iron ore. In short, Australia has the goods.
Changing tide

Quite apart from the actual price, the benchmark pricing system is waning in significance for the miners and by proxy share market investors. The system was designed by the miners to protect the massive capital investment required to get the ore out of the ground.

However, the rapid development of the spot market and the turmoil over the last year has highlighted the advantages of a more flexible system for settling iron ore prices.

For example, when steel prices tumbled last year amid signs of waning global economic growth, some producers either demanded renegotiation of the contracts or defaulted.

Such developments pushed miners such as Mount Gibson Iron to the brink of bankruptcy.

BHP is leading the charge for a new order and is targeting a system where prices are set relative to a bench mark index.
It argues such a method of settling the price would eliminate the risk of default by consumers of ore as it would lower their production costs in line with prevailing economic conditions.

BHP also says such a system would provide better signals to the market about the state of demand and supply and would foster the development of an iron ore futures market, which would replicate many of the benefits of the benchmark pricing system.

The old system is unlikely to be abandoned overnight. Critics of the move, for example say it will give iron ore giants such as BHP too much power. However, the mere fact that an industry heavyweight such as BHP, one of the world’s lowest cost producers, is lending its muscle suggests the benchmark system has had its day.

Richard Inder is an investment adviser at Macquarie Private Wealth. His disclosure statement is free and is available on request. Clients may hold shares in the firms mentioned. Comments, think differently? Write to richard.inder@macquarie.com