Historic Agreement Ends 40 Year Old Iron Ore Benchmark as Miners Get Short-Term Pricing Contracts

In a historic moment for commodities markets, two of the world's largest iron ore producers, Vale SA (NYSE ADR: VALE) and BHP Billiton Ltd. (NYSE ADR: BHP) signed short-term contracts for record prices with Asian steel mills that effectively replace a 40-year-old system of setting prices annually.

The landmark move by Vale and Anglo-Australian BHP ended the annual benchmark system when they signed new short-term deals linked to quarterly prices on the spot market, with the Brazilian company winning a 90% increase. Another large iron ore producer, Rio Tinto PLC (NYSE: RTP) has yet to sign any new contract, but is expected to soon follow.

The primary mineral used in steel, iron ore directly affects steel prices and the cost of everyday goods, including refrigerators, cars, and washing machines. That made the recent negotiations one of the most important issues for the global economy and commodity markets.

The shift from benchmark contracts - where the two sides hammered out prices that kept the price of iron ore the same for a year's time - to short-term pricing was a "momentous" day, according to Brendan Harris, a mining analyst at Macquarie Group Ltd. (OTC: MQBKY).

"It's not every day that the pricing terms for one of the core commodities in world trade change," he wrote in a note to clients obtained by The Financial Times.

Vale signed a deal to provide Sumitomo Metal Industries Ltd., Japan's third-biggest steelmaker, with iron ore at prices of $100 to $110 a metric ton for the quarter starting April 1, spokesman Toshifumi Matsui told Bloomberg News. BHP said it will sell the majority of its production to Asian steel mills on shorter-term contracts but didn't reveal prices.

The new agreements mean that the miners will receive a 90%-100% increase from the $60 level where the 2009-10 annual contracts were settled, industry executives said. The short-term nature of the deals means prices are likely to rise again later in the year.

"This represents a significant win for BHP Billiton over Asian steel mills who have long resisted the move away from annual contract pricing," Ben Potter, an analyst at IG Markets Ltd. in Melbourne told Bloomberg.

China, the largest buyer of iron ore, is still in price talks with the three biggest producers. Some Chinese steelmakers have privately reached deals with the suppliers though official talks are ongoing, Deng Qilin, general manager of Wuhan Iron & Steel Group, told The Wall Street Journal earlier this month.

The negotiations to end the traditional pricing structure and a shortage of iron ore have increased tensions between producers and steelmakers.

Jia Yinsong, a senior official with the Ministry of Industry and Information Technology official, said that China "definitely supports the [existing] iron ore benchmark system," and called miners' demands "not transparent and not representative of market fundamentals."

A senior official from the China Mining Association on Tuesday publicly slammed the new agreements.

"There has to be a reasonable price," Wu Rongqing, the association's chief engineer told The Journal. "If upstream miners take all the profit, what will our steel mills do?"

A senior Vale executive said the annual iron ore benchmark pricing system is "over."

"The benchmark system didn't survive a serious test last year," Pedro Gutemberg, Vale's marketing, research and development director, said at an industry conference in Beijing. "Something different should be done...We don't want never ending confrontation."

China's insatiable demand over the last decade has steadily driven the price of iron ore higher. The big miners for years have been trying to change iron ore pricing to reflect actual supply and demand at the time of sale. With demand outstripping supply, iron ore has become the biggest moneymaker for many of the world's miners.

After prices plunged 68% between February and October 2008 during the global recession, Chinese steelmakers decided to abandon the contract prices and buy more iron ore on the cash markets. Prices have more than doubled since.

The shift to short-term deals will benefit Rio Tinto and BHP in particular, as they can return higher profits due to lower freight costs.

Iron ore is a bulk commodity that Asian steel makers pay miners to ship across the ocean to their ports. Most of BHP's and Rio's mines are in Australia, much closer to China and the rest of Asia, than Vale's Brazilian mines.

It cost about $11 a ton to ship iron ore from Australia to China, compared with about $25 a ton from Brazil, where Vale has its main operations, according to The FT.

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