Skyrocketing Iron Ore Prices Squeeze Steelmakers' Profits

Steelmakers' profits are shrinking as iron ore suppliers saddle them with steep cost increases.

Even though the world's biggest iron-ore miners are digging up record amounts of the black rock, demand is outstripping supplies.  That's allowed producers to boost prices, continuing the upward momentum that got underway in the second half of 2010.

However, steelmakers have been unable to pass all the increases along to end users and are warning that raw material prices are likely to depress their earnings for most of the 2011 fiscal year.

South Korea's Posco (NYSE ADR: PKX) earlier this month reported that fourth-quarter profits in 2010 fell 60% from the year before, partly due to a steep rise in prices for iron ore and coal – the two main ingredients in the production of steel.

Posco said its iron-ore costs rose 8%, and the steelmaker expects prices to continue to climb.

"We expect rises in raw materials, but it is difficult for us to fully pass along the costs to products," said Posco Chief Executive Chung Joon-yang during the company's earnings release earlier this month.

Another heavy importer of iron ore, Japan's Nippon Steel Corp., is expected to say in its earnings release next week that its profits are also being dragged down by rising iron-ore prices, The Wall Street Journal reported.

Iron ore prices are forecast to increase by approximately 22% in the first half of the year, with China continuing to be the main importer of the mineral, Rafael Weber, Geraçao Futuro brokerage's mining and steel analyst, told Business News Americas.

Brazilian miner Vale (NYSE: VALE), the world's largest iron ore producer and exporter, has already set a price hike of 7-8% for the first quarter, according to Weber.

Additionally, if spot prices maintain their current levels through February, prices will increase by a further 12-13% in the second quarter, Weber said.

"For the second half of 2011 it's still premature to make forecasts on new adjustments," he added. "That will depend on what spot prices are in the second quarter."

The price of iron ore is hovering around $186 a metric ton, matching a two-year high reached in April 2010, according to the Platts index.

Vale and the two other largest miners of iron ore, Rio Tinto PLC (NYSE ADR: RIO) and BHP Billiton Ltd. (NYSE ADR: BHP) rattled the commodity markets in 2010 by abandoning annual contracts and switching to a quarterly pricing system.

Steelmakers globally have been heavily impacted by the change in the iron ore pricing policy, which drastically affected their cost structures and put an end to a 40 year-old tradition.

But recent reports said BHP could be moving even further by trying to sell more of its iron ore on a demand/supply basis, which would put an end to the mismatches between quarterly contracts and spot prices.

"We would like the market price of the day, every day, for all of our commodities as we believe that transparent prices are good for consumers and good for producers," BHP Chief Executive Officer Marius Kloppers told analysts last year.

Rio Tinto, Vale and BHP Billiton are reporting that they are extracting iron ore, one of their most profitable products, at a record pace.

Rio Tinto reported its global iron-ore operations set a new quarterly production record of 65 million metric tons and a new annual record of 239 million metric tons. BHP said iron-ore production in the quarter rose 4% from the year earlier.

Meanwhile, steelmakers are trying to boost their own prices to offset the more expensive raw materials.

The world's second-largest steelmaker, China's Baoshan Iron & Steel Co., already has announced price increases of 3% to 7% for some of its key products, The Journal reported.

In North America, the price for hot-rolled coil, a basic steel product, is up about 20% since November.

Steelmakers around the planet are expected to follow suit, but whether the increases stick will depend on supply and demand in a particular region. Prices are likely to go higher in emerging markets like Brazil and China, where demand remains relatively strong for finished steel products. But in places like South Korea and North America, the price increases will be harder to implement.

U.S. steel mills are running at about 70% to 75% of capacity. While that's a profitable level, it's not indicative of very strong demand.

"The sustainability of such steel hikes is highly questionable," said Barclay's Capital analyst Leonardo Correa in his research report earlier this month, according to The Journal.

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