A rebound in iron ore prices? Who knows?

By Jason West, Griffith University

Forecasting commodity prices is like buying a second hand car. Only the car’s previous owner and perhaps the dealer really know what the car is actually like. In contrast you, the buyer, are an outsider with very limited insight and can only judge the car’s true value by what you see in the car yard. Second hand cars, and iron ore, are classic cases of asymmetric information at work, pioneered by George Akelof’s 1970 study on the market for lemons.

In 2008 BHP Billiton grew tired of the practice of selling iron ore to China at an annually negotiated and hard fought fixed price of around $120 per tonne only to see its competitors in India selling iron ore in the spot market at prices of $300 per tonne.

The company was selling iron ore directly to many of the large and some smaller steel makers in China at annually agreed benchmark prices, only to see them sell it on to other producers at much higher spot prices. Steel producers could now make more money from trading iron ore than making steel. Many smaller steel producers simply shut down their blast furnaces, traded iron ore and retreated to the local tea house to watch the money rolling in.

Iron ore was one of the last of the heavily traded commodities that could not be readily bought and sold by intermediaries. So BHP Billiton got serious. BHP Billiton jump-started the market started by donating around two million tonnes of iron ore to form a spot market to entice a limited number of “informed” (sanctioned) intermediaries (not speculators) to provide liquidity and establish a floating price index against which their contracts could be priced.

The dominant iron ore producers desire a floating price index for iron ore that reflects global steel demand. But they also want to sell iron ore directly to steel producers, and avoid pesky brokers, traders and speculators in between. These intermediaries are regarded by the producers as market parasites latching on to their hugger-mugger marketplace to undercut prices and destroy value.

A floating index is only effective if such intermediaries are present and are freely allowed to trade. Traded volumes of iron ore barely reach 80% of the total global volume of iron ore produced. This is better than zero, as it was prior to 2008. But compared with copper and other metals, whose traded volumes in futures and other derivatives often exceed 100 times their production volume, the iron ore market is stale. The iron ore price index relies upon buyers and sellers to report their transactions to a data compiler, and only a few transactions are ever reported. This is unlikely to improve.

An efficient market is regarded as one where prices reflect prevailing demand and supply conditions. There will naturally be price volatility. Prices for copper or bananas are generally seen as the squiggly line of a random walk and contain inherent volatility, with some price jumps. In contrast, iron ore prices exhibit a volatility all of their own and are capricious in a different way. Instead of a large number of minor price changes with a few large price jumps reflective of normal market activity, iron ore prices are not continuous and mostly only jump up or down. Sometimes the prices changes are quite extreme, taking the market by surprise even though this type of behaviour is expected in a market with limited trades.

This is largely a function of the commodity itself. Iron ore is sold in large parcels to buyers and supply interruptions can trigger price changes as demand spikes. But critically, the fact that the dominant producers have elbowed speculators out of the market, while reluctantly acknowledging their necessity to maintain market liquidity, has created a volatile iron ore price index of questionable relevance to market observers.

This does two things. First, forecasting iron ore prices becomes tricky. Most of the forecasts will be wildly wrong because of the jumpy and largely opaque nature of how the price series is generated. And second, because forecasts are difficult, the Federal Treasurer and his Treasury have no idea how much tax revenue is due to them from iron ore sales, either through normal corporate tax receipts or via the MMRT because the forecasts will be wrong.

Squeezing speculators from the iron ore market has allowed the dominant producers to maintain market secrecy under the guise of price discovery. Until speculators penetrate the iron ore trade, forecasting prices in the market for lemons (and iron ore) will remain a mystery.

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Jason West does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.

This article was originally published at The Conversation. Read the original article.