The impact of commodities prices on mining companies

I have been reading that iron ore and coal export prices are due to be negotiated in the near future? Can you tell me how the process works and where I can find the results of the negotiations and final pricing outcome? Also what short term impact does this have on mining company’s share price?

Response:

The issue of iron ore and coal export prices has come under scrutiny lately as large participants like BHP Billiton look to reform the current pricing mechanism. As it stands, prices for Iron Ore and Coking coal (used to produce steel products) are negotiated annually between major buyers and sellers of the commodity and the resulting price is set as the benchmark for the following year. This annual negotiation process is dominated by the needs of European, Chinese and Japanese steelmakers who use iron ore and coking coal in the steel production process.

For thermal coal, used to generate electricity and heat, an index has been created known as the globalCOAL energy index. This index has proved successful and has formed a template for possible indexes for iron ore and coking coal. The indexed commodity means that both short and long term contracts can be bought and sold, and the spot price is often much higher than the annual contract price. In essence, a market does not need to be created.

For example, the globalCOAL spot price of coal from Newcastle, Australia is $US76.95 a tonne, well above this year’s contract price of about $US52 a tonne. This also means that companies like BHP who seek a premium for commodities like iron ore and coal given their proximity (relative to the South American producers) to big-ticket consumers like China and Japan, can use spot markets to try and achieve what is known as freight equalisation whereby they trade contracts of different length to bring the cost into balance.

It is here that the process becomes quite complex, so I will limit this discussion to the impacts of the current pricing process.

To give you an understanding of the current process I will discuss the status quo for annual iron ore contract negotiations. Each year the world’s three biggest iron ore producers, Australia’s BHP and Rio Tinto, and Brazil’s Companhia Vale do Rio Doce (CVRD) sit down separately with steelmakers around the globe (led by Chinese and Japanese makers) to negotiate prices known as the annual contract price. With the 2008 negotiations recently commencing, many pundits expect an export price increase for the $16 billion dollar annual trade of Iron Ore. Typically these negotiations take place between December and March, depending on commercial climate and independent stakeholder’s acquiescence to the pricing outcome.

The nature of these negotiations are not public record so there is an element of mystery surrounding the goal of setting a price that is adopted by both buyers and sellers; However, the price is reached when the first iron ore producer settles with the first steel mill. The determined price applies from April 1 to March 31, categorised as a Japanese financial year and is in US dollar denominations, which facilitates a comparison. The results of the negotiation and official contract price for the coming year are posted on CVRD’s (the largest Iron Ore producer) website.

Strengthening demand from the world’s fastest growing economies like China (who also account for a third of the world’s steel output) has meant that the annual contract prices for coal and iron ore have been rising significantly year-on-year. For producers this means a correlative contribution to their earnings forecast. It is risky to speculate about short-term market movements, but typically an increasing benchmark price puts upward pressure on the share price of companies like BHP, RIO and Fortescue.

Disclaimer:
The information in this article is general in nature and does not take into account any investor’s particular objectives, financial situation or needs. In considering its appropriateness, investors should read the relevant product disclosure statement and consult a financial adviser before making an investment decision.