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The Pine Valley open pit coal mine in the Peace River District of northeast British Columbia (JOHN LEHMANN/The Globe and Mail)
The Pine Valley open pit coal mine in the Peace River District of northeast British Columbia (JOHN LEHMANN/The Globe and Mail)

A losing bet on coal and iron ore Add to ...

Last spring, the world's bigger miners forced Asian customers to make a dramatic switch, abandoning a 40-year tradition of annual price contracts in favour of three-month agreements.‬‪ ‬‪

The buyers feared the new arrangement would drive up prices. The miners hoped it would. So far, they've both been wrong.‬‪ ‬‪

Prices for coal and iron ore, two key ingredients in steelmaking, have fallen by up to one third on the spot market, pulled down by a slowing global economy and an oversupply of steel that has resulted in production cuts in China, the world's largest steel producer.

Slumping prices will probably mean lower prices for the next round of quarterly contracts, terms of which are now under negotiation.

Depending on how low prices go, and for how long, miners may wish they had stuck to the old, more stable contract system.

"All we know for sure is that the dynamics of the Chinese steel market will be increasingly influential in determining pricing, and revenues for the miners will inevitably be more volatile than under the old annual benchmark system," Goldman Sachs said in a recent report. "Welcome to the brave new world of index linked pricing!"

After months of lobbying by BHP Billiton, Vale SA and Rio Tinto, as well as Canada's Teck Resources Ltd., the new system of quarterly price contracts started in the second quarter of this year, in what is traditionally the start of the fiscal year for coal and iron ore producers. The prices for each quarter are negotiated ahead of time, based upon current market conditions.

For the April-June contract period, metallurgical coal, used in steelmaking, was locked in at around $200 (U.S.) per tonne. That price rose to around $225 in the July-September quarter, thanks to spot prices that rose to about $260 in April. Since then, prices have fallen to about $210 per tonne.

Iron ore prices have also dropped to about $122 per tonne, after peaking at $185 per tonne in April.

"With spot iron ore trading at a discount of over 20 per cent to the implied third-quarter contract price, the new quarterly pricing mechanism is clearly under duress," Goldman Sachs said, calling the new quarterly average index system "cumbersome."

It is unlikely mining companies will revert back to annual contracts. Many analysts speculate that the next move will be to monthly contracts, and more buying on the spot market.

The rate of increase in steel production has been slowing in the past few months as China's economy cools, Europe works through its debt troubles and growth stutters in the United States.

Global steel production was up 18 per cent in June compared to a year earlier, but much slower than the 28 per cent growth seen in the first six months of the year, according to the World Steel Association.

Global steel production fell almost 5 per cent in June compared to the month before, with Chinese production falling 4.2 per cent.

South Korean steelmaker Posco recently cited high coal inventories and a drop in China's domestic coal price as factors behind falling spot prices. Meantime, BHP, the world's largest mining company, cautioned that reduced commodities consumption by China is going to dampens the outlook for iron ore.

"Within China, measures introduced to reduce growth to more sustainable levels means volatility in commodity end-demand is likely to persist," BHP said in its latest production report.

China is already reported to have cut back production at some of its steel plants, with more cuts coming.

"This implies downward pressure on the already correcting spot iron ore and metallurgical coal markets throughout the summer," BMO Nesbitt Burns said in a recent note.

Still, many analysts are predicting a turnaround later this year as inventories adjust.

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