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Captains of Iron Ore
IT was supposed to be fair winds and following seas. For much of 2018, the good ship "Iron Ore" drifted along with breezy supply and a steady tug of demand through a narrow channel of US$64-US$74 a metric tonne. Market lookouts in the crow's nest declared not a cloud of price shock on the macro horizon: an economic slowdown was depressing downstream demand in China, where most of the world's iron ore goes into steelmaking for infrastructure, cars and machinery. Interminable US tariff talks splashed cold water over animal spirits, leaving Chinese consumer and business confidence at 30-year lows.
Then on Jan 25, a tidal wave roiled the market. A tailings waste dam at Brazilian iron ore giant Vale SA's Córrego de Feijão mine had collapsed with devastating impact. Brazil, a major iron ore producer, is forecast to lose at least 50 million tonnes of exports this year - over 2 per cent of global supply - as Vale curtailed output and decommissioned similar mines for safety checks. With spillover waves of preventative regulations expected, more Brazilian seaborne supply could now be at risk.
This supply-side shockwave, exacerbated by rains in Brazil and a cyclone in Australia, pushed iron ore prices 10 per cent higher in January and another 15 per cent in February. Short-term volatility surged to 40 per cent, the highest since mid-2017 and well above gold or oil. Producers took advantage as the market rolled on a three-year high swell of US$90-US$95 a tonne, while traders and steelmakers were forced to change course and cover against further losses.
RISK MANAGEMENT OF FREIGHT AND CARGO
Losses at sea once encouraged the very first management of "natural" - nature-borne - market risks. The earliest methods of risk distribution can be traced even to the third and second millennia BC, when Chinese and Babylonian laws provided for a basic insurance premium for loans by merchants to secure ship voyages. Over time, larger trading fleets and the recurrence of significant losses at sea encouraged more refined techniques: the London shippers and traders in Lloyds' coffee house in 1686 established our modern forms of maritime insurance and reinsurance.
Nowadays, thankfully, commercial vessels or cargoes are rarely lost at sea - and risk management has evolved instead to insure against the highly volatile cost of freight, and the equally volatile price of shipped bulk cargoes. In shipping, this is achieved through freight derivatives that are indexed to global benchmarks published by the Baltic Exchange, part of the Singapore Exchange (SGX) family. Today, SGX and Singapore dominate global clearing for freight derivatives.
Even though Singapore is neither a producer nor consumer of seaborne commodities, SGX is flying the nation's flag high in these international waters. By offering diverse risk-management tools such as swaps, futures and options, we help merchants and principals manage the impact of fluctuations in commodity cargo prices. In 2018, SGX cleared over 1.3 billion tonnes of iron ore derivatives - more than the volume of the entire physical seaborne market and accounting for close to 100 per cent international market share. In this way, Singapore is a high beacon for global shippers and commodity traders seeking the confidence to navigate safely through the rough seas of international markets.
DECADE OF IRON ORE DERIVATIVES
This year marks 10 years since SGX pioneered the world's first cleared iron ore swaps, and our role in shaping global risk management has never been more relevant. Iron ore markets have grown in lockstep with China's economic rise to become Asia's first truly global commodity, following in the footsteps of the oil complex in Europe and the US. As the raw material for the backbone of global industrialisation and urbanisation, iron ore is evolving into a fundamental portfolio factor for institutional investors. The number of global financial market participants in SGX's iron ore markets is climbing every month.
Steelmakers globally are being challenged by expensive changes to their raw materials mix, stemming from regulatory pressures to limit emissions of sulphur and particulates from steel mills near densely populated urban centres across Emerging Asia. In turn, global miners are under pressure to produce higher-quality ores and are facing more stringent safety and governance standards, amid fierce cost competition. In times of price volatility, rapid fluctuations in costs or revenues stress further the cash flows of such asset-heavy industrial operators. Tightening environmental regulations are expected to force ever more highest-cost or worst-polluting steelmaking operations offline, and mothball some junior mining assets with the weakest economies of scale.
SGX's launch in December of high-grade iron ore derivatives - another world-first - means risk management has become even more effective for surviving market champions. High-grade contracts add vibrancy by offering hedgers and investors the opportunity to manage widening basis risks between premium 65 per cent iron ore and the standard 62 per cent benchmark. Through this price spread, producers and traders - with critical raw material and transport choices to make - can express views on macroeconomic trends, or on regulatory outcomes in Brazil versus Australia. For end-users, it is an important new tool for steel-mill margin hedging, with which to better pilot for calm seas or unpredictable storms in the iron ore market.
Back on the good ship "Iron Ore", our market lookouts are swaying in the crow's nest. They are pointing to more brooding dark clouds of volatility ahead: these looming, unpredictable squalls are now gathering on the demand side of the market.
Chinese metal demand, a function of credit availability for local governments and businesses, has had its sails filled by a strong state-approved credit injection during the first quarter, about 40 per cent higher than last year. Rising home prices and a strong GDP call for China of 6.4 per cent, defying downbeat expectations, are the latest signals of a stimulus-driven recovery. Steel demand, prices and margins may hold if Beijing rolls forward with tax cuts, greater issuance of infrastructure bonds, and spending on construction under its Belt & Road Initiative.
At the same time, other lookouts are pointing further to the horizon, where China faces macro and geopolitical crosswinds of accumulating debt, ageing demographics and environmental pressures on heavy industry such as mining and steelmaking. A renewal of US and China trade tensions would result in a drag on global growth. And commodity market captains also need to weather the once-in-a-decade risk event of the International Maritime Organization cutting sulphur in shipping bunker fuel from 2020, with potentially higher prices for dry-bulk freight vessels carrying ores, coals and steel globally along their risky seaborne supply chains.
Price swings of nearly 50 per cent are an all-too-typical story in the history of seaborne commodities. For all merchants of enterprise on commodity seas, navigating such sudden squalls and hidden underwater hazards can be daunting. Political storms, tariffs, weather, supply shocks or seasonal demand swings - all these influence market price in unexpected ways, and the dominant direction of invisible gusts or currents is not easily predicted, even by veteran observers of wind and wave. All this uncertainty makes a strong case for better management of risks, known and unknown.
- The writer is head of derivatives at Singapore Exchange