A new Chinese benchmark is emerging to help the iron ore traders to manage price risk in an increasingly volatile market. The iron ore market has undergone major structural changes over the past two decades, the most notable of which was the transition from annual fixed price contracts to spot index-based pricing. This led to the creation of a futures market based on the spot index price which has been further enhanced through the development of an onshore China iron ore market.
From seaborne to onshore
For many years, international trading houses have been buying seaborne cargoes and selling to counterparties at China’s ports, creating a secondary market where ores are traded domestically and in smaller lot sizes. In comparison to the seaborne prices, which is quoted in U.S. dollars per dry metric ton, the portside prices represent the Chinese yuan per wet metric ton value of iron ore available for the cash market with VAT and port fees included in the prices.
This onshore market has been gaining importance in iron ore pricing and this is helping to support China in a push for additional price discovery at its ports, and as more mining companies join the onshore market to be closer to the end user community.1 With the increased participation, the portside iron ore market serves as a key price discovery mechanism which reflects domestic demand more closely and forms a distinct but complementary market to the existing seaborne markets.
The basis between the seaborne and the domestic portside market has been volatile, and this has boosted calls for additional price risk management products for the domestic markets. To provide the market with the appropriate risk management products, in January 2022, CME Group launched two new futures contracts - Iron Ore China Portside Fines CNH fot Qingdao (Argus) futures and Iron Ore China Portside Fines USD Seaborne Equivalent (Argus) futures. Both contracts are based on indices published by Argus Media and are the first internationally traded derivatives linked to China’s portside prices. The contracts are specifically designed to help market participants manage their onshore iron ore price at Qingdao Port in China.
Domestic iron ore prices remain volatile
For entities involved in the China onshore markets, the CNH Portside futures can serve as a more precise tool for price risk management as compared to the Seaborne futures, which are priced in U.S. dollars. On the other hand, the U.S. dollar-denominated contract allows market participants gain access to China onshore price in the same currency of the seaborne iron ore contracts. Therefore, trading seaborne against portside spreads may be more easily implemented. There is early adoption by market participants for these futures and 1,000 contracts have traded since launch.
China steel mill hedges against iron ore price rises
Each market participant may have its own trading and hedging strategies, but the following hypothetical example shows how a steel mill can use the Argus PCX portside iron ore index and futures market to lock the cost of its iron ore purchase.
Scenario: A steel mill purchases their spot physical iron ore at the portside market and agrees with their supplier to price the purchase based on the Argus portside index.
In November 2021, the spot market is ¥650/wmt and the steel mill purchases 20,000 mt physical iron ore. The purchase price is based on the Argus PCX portside iron ore average for January 2022. At the same time, in the derivatives market, the mill also buys 200 lots of January 2022 Iron Ore China Portside Fines CNH fot Qingdao (Argus) futures contracts at ¥640/wmt. The Portside futures contract is financially settled based on the Argus PCX index published each day in the contract month. The contract size is 100 mt, therefore 200 lots is equivalent to 20,000 mt.
At the end of January 2022, the iron ore market rises to ¥900/wmt and the average price in January is ¥850/wmt at which both the physical and derivatives trades settle. The mill purchases 20,000 of iron ore from its supplier at ¥850 which costs 17 million yuan. In the derivatives market, the 200 lots of January futures contracts final settle at ¥850, making a profit of 4.2 million yuan (¥210 x 200 lots x 100 mt). The final cost of the iron ore purchase with the hedge is 12.8 million yuan or ¥640 per ton.
Physical |
Futures |
Hedge Result |
|
|---|---|---|---|
November 2021 |
Agrees to buy 20,000 mt of physical ore from supplier at Argus PCX index January average |
Buys 200 lots of January 2022 Portside Iron Ore futures at a price of ¥640/wmt |
|
January 2022 |
Buys 20,000 mt of iron ore at ¥850/wmt which is Argus PCX index January average |
200 lots of Portside Iron Ore futures expire at the end of January. The final settlement price is ¥850/wmt which is Argus PCX index January average |
|
Cost and Profit/Loss |
Purchase price: 20,000 mt x ¥850 = 17,000,000 yuan |
Profit: 200 lots x 100 mt x (¥850 - ¥640) = 4,200,000 yuan |
Final Cost (“Net Purchase price): 17,000,000 - 4,200,000 (Futures gain) = 12,800,000 yuan (¥640 per mt) |
China remains key for pricing mechanism evolution
The rise of China’s dominance in global iron ore trade has brought about several changes in the way the commodity is priced since the new millennium. A move to a more spot-based market is a huge step forward in the pricing flexibility between the buyers and the sellers. Previously, the large industrial buyers in countries like Japan negotiated long-term fixed price contracts with the big miners. Typically, such agreements would be around a duration of 12 months. Increased spot price volatility made the viability of such contracts more difficult. An index-linked market quickly emerged and further developments such as the onshore China market were the next step in the market evolutionary process.
Sitting at the heart of global iron ore demand, the fast-growing China portside market has emerged as a key indicator of price trends in addition to the seaborne iron ore market. It is regarded as a vibrant market with wider firm participation trading in more flexible quantity. This created increasing needs to actively manage the price risk of portside iron ore and the seaborne-portside spread. The listing of Portside Iron Ore futures at CME Group now helps market participants to hedge the onshore price risks directly, and to manage the seaborne-portside price spread more effectively.
CME Group launches new China Portside Iron Ore contracts – key characteristics2
|
IRON ORE CHINA PORTSIDE FINES CNH, FOT QINGDAO (ARGUS) FUTURES |
IRON ORE CHINA PORTSIDE FINES USD SEABORNE EQUIVALENT (ARGUS) FUTURES |
|---|---|---|
Product Code |
PAC |
PAU |
Contract Size |
100 MT |
100 MT |
Settlement Type |
Financial – Final settlement is based on the average of the settlement index published each day in the contract month. |
Financial – Final settlement is based on the average of the settlement index published each day in the contract month. |
Price Quotation |
CNH per wet metric ton |
USD per dry metric ton |
Minimum Price Fluctuation |
¥0.1 per wet metric ton |
$0.01 per dry metric ton |
Settlement Index |
Iron ore portside fines 62% Fe (PCX) fot Qingdao assessment by Argus |
Iron ore portside fines 62% Fe (PCX) seaborne equivalent assessment by Argus. The seaborne equivalent price is converted from the Iron ore portside fines 62% Fe (PCX) fot Qingdao by adjusting for moisture content, VAT, port fees, and converting from RMB into USD. |
References
- Portside Iron Ore: The Future(s) King by Argus https://view.argusmedia.com/rs/584-BUW-606/images/MET-December%202022%20Portside%20iron%20ore%20The%20future%28s%29%20king.pdf
- Detailed contract specifications are available at https://www.cmegroup.com/markets/metals/ferrous/iron-ore-china-portside-fines-cnh-fot-qingdao-argus.contractSpecs.html and https://www.cmegroup.com/markets/metals/ferrous/iron-ore-china-portside-fines-usd-seaborne-equivalent-argus.contractSpecs.html
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
