China launched its first iron ore contract on Friday, for the first time providing local steel mills a way to hedge their main input costs without taking on foreign currency exposure. If successful, the contract could for the first time put iron ore pricing power into Chinese hands.

 

Chinese steel mills, backed by Beijing, fought for years to gain the upper hand in iron ore price negotiations with the world’s top iron ore miners. But it remains to be seen whether the new contract on the Dalian Futures Exchange can displace the $28bn international iron ore swaps market or become the trading benchmark for the billion tonnes of seaborne iron ore traded annually.

Steel traders said the success of the futures contracts would depend in large part on whether giant iron ore miners BHP Billiton, Rio Tinto and Vale, which together produce about two-thirds of the world’s traded iron ore, use the Dalian futures contract. BHP, for one, has a general policy of selling at prevailing market prices rather than trading futures.

"It would need to have buyers and sellers together before it can be considered a price setter. There’s a long road to go,” said Hu Yanping, chief analyst for metals information firm UMetal in Beijing.

The iron ore market is already far more transparent and liquid than it was in the past, when annual iron ore price negotiations created international friction and the large discrepancy between fixed annual contracts and volatile spot markets opened room for arbitrage and corruption.

The most active May contract in Dalian closed at Rmb977 ($155) per tonne, broadly in line with the international indices against which Chinese spot iron ore imports are priced. If successful, the futures contract could help displace those indices, including the current benchmark developed by market pricing firm Platts.

Volume in the May 2014 contract, which is backed by physical delivery, reached more than 300,000 lots – the equivalent of 15m tonnes of iron ore.

To put those figures in perspective futures contracts on the Singapore Stock Exchange trades the equivalent of 1-2m tonnes a day or iron ore.

"China now has complete representation of the “virtual” long-product steel mill, from rebar to coke to coking coal and iron ore,” said Melinda Moore, analyst at Standard Bank.

Major sellers are not the only ones to stay on the sidelines. Chinese state-owned metals companies have had spectacular missteps in trading zinc, copper, and oil futures, and while many mills have designated personnel to familiarise themselves with futures, they remain cautious about exposing themselves too much.

Thermal coal, coking coal and coke futures now also trade in China, so the addition of the iron ore contract will ultimately allow Chinese mills, which struggle with severe overcapacity, to hedge the range of important inputs. Rebar futures on the Shanghai Futures Exchange have already helped bring more pricing transparency for steel.