Research Briefing

July 29, 2010 Turbulence in the steel market

— Radical changes in the iron ore market: shortening of contract periods
Economics & politics

and orientation to spot price as benchmark.

— The changes will result in greater planning uncertainty and increased
volatility for all industries along the value chain.
— The steel industry feels it has no choice but to pass on the higher cost of
raw materials to users and is seeking to boost steel prices.
— The order upswing in steel-processing industries will be curbed by the
rising price of steel.
— Higher steel prices will be passed on to the end consumers of steel
products.
— While the related raw material prices have already peaked, steel price
hikes will hinge on the development of the global economy.

New pricing system for iron ore has taken root

The two key raw material inputs for steel production are iron ore and coking
coal. In the coking coal market, the establishment of quality standards and the
development of an online trading platform have already led to the emergence
of reliable indices that are the basis for brisk business in forward transactions.
The iron ore market is currently witnessing similar developments. The aim is
greater flexibility in iron ore trading. The idea is for a reliable benchmark price
to develop that enables price fluctuations to be hedged using derivatives. The
evolution of a new pricing system in the iron ore market will lead to changes
along the entire value chain in the steel sector, for from now on the mining
companies plan to conclude contracts with steelmakers on a quarterly basis
instead of annually. The terms are to be geared to the spot price for iron ore.

Increasing demand for iron ore

As the global economic recovery gathers steam, iron ore demand and prices
are generally resuming their upward climb. Not only the mining companies’
Author
Lisa Fey
strong negotiating position but also growing demand from China is boosting
+49 69 910-31875 the price. In 2008, China imported 48% of the world’s iron ore exports, with
oliver.rakau@db.com the EU-27 countries following at 20% and Japan at 15%. In 2000, Chinese
Editor imports absorbed only about 13% of worldwide exports (EU-27: 33%). While
Tobias Just
China does have iron ore deposits, according to the Raw Materials Group
Technical Assistants
Chinese production peaked in 2008 at around 366 million tonnes. Because
Sabine Berger
Sabine Kaiser the iron content of the ore produced in China is some 20% lower than that of
Deutsche Bank Research
output elsewhere in the world, the rising demand for high-grade iron ore
Frankfurt am Main cannot be met from domestic sources. Moreover, the mainly small-scale
Germany mining operations there do not have the facilities for extracting the iron ore still
Internet: www.dbresearch.com
E-mail: marketing.dbr@db.com to be found in deeper strata of the Earth’s crust.
Fax: +49 69 910-31877
Managing Director
Thomas Mayer
 Research Briefing

Iron ore output increasing Since 2000, the volumes of iron ore produced worldwide have
Tonnes (bn) increased in India and China in particular, while Russia’s share in
1.8 the total has halved. Contributions to world production in 2008 came
1.6
1.4 to about 20% each from Brazil, Australia and China (2000: 20%,
1.2 20%, 10%). The EU-27’s share of output is marginal. Taiwan, Japan
1.0
0.8
and South Korea satisfy 100% of their demand via imports, while the
0.6 EU-27 imports 84%. China’s demand outstrips its own supply, which
0.4 is why China’s net imports absorb 55% of total demand (2000:
0.2
0.0 39%). By contrast, Australia, Brazil and South Africa export the bulk
00 01 02 03 04 05 06 07 08 of their output. 70% of overseas trade in iron ore is conducted by
Australia’s BHP Billiton and Rio Tinto as well as Brazil’s Vale. This
ROW Russia India concentration of the ore trade leads to pronounced import
Brazil Australia China
dependence for countries with robust demand for iron.
Source: WSA 1
At present, the lion’s share of iron ore is sold over the counter via
bilateral agreements, so it only takes a few contracts on the spot
China dominates demand market to influence the price. It is this price, in turn, to which the
for iron ore
Tonnes (bn) prices in the bilateral quarterly contracts are linked. The miners
1.8 would like to see the market become more liquid and pricing more
1.6 flexible; financial market participants see opportunities in the
1.4
1.2 creation of derivatives and in spot market trading. Currently, only
1.0 small volumes of iron ore derivatives are traded, but analysts expect
0.8 these to increase and reliable price indices to be established. Steel
0.6
0.4 companies now fear that iron ore prices might decouple from
0.2 demand in the manufacturing industry. There are in fact indications
0.0 of iron ore inventories being run up, with supply thus being
00 02 04 06 08 1
withdrawn from the market as a result.
Russia India Japan
EU-27 China Other Differing assessments of the supply situation
Source: WSA 2 Mining operators claim that iron ore is currently scarcer than is being
priced in and they use this as an argument to explain the price rise.
Oligopoly in overseas iron However, 5% of the Earth’s crust is composed of iron ore and there
ore trade are still large untapped deposits around the world. Over the past few
Share (%)
years, though, little has been invested in increasing the mines’
100 output, a fact that is likely to change now given the soaring price of
80 iron ore. The west coast of Africa still offers potential with several
60 billion tonnes of deposits. The largest proven deposits are to be
2
40 found in Australia.
20
0
Impact on steelmakers
Overseas trade Production The steel producers have no choice but to accept the changes to
2008 2009 the contract conditions pushed through by the iron ore oligopolists.
The individual steel producers do not have a very strong negotiating
BHP Billiton Rio Tinto Vale Other
position on import prices, the reason being the heavily fragmented
Sources: UNCTAD, AME 3 market structure in comparison with iron ore trading. Both the spot
market benchmarking of coke and iron ore contract prices as well as
the shorter contract periods have a substantial impact on steel
Polypoly in the steel
market production: prices are now more volatile and the reliability of costing
Market shares of top 5 (2009) procedures has become very limited. Various approaches are being
6.3 2.6 adopted by the steelmakers to tackle these problems: the trend
2.5
towards vertical integration of raw materials suppliers and steel
2.2
2.1
producers is unbroken. In 2009, ArcelorMittal procured 64% of its
supplies itself and says it wants to further increase this share in
order to reduce its dependence on major ore producers.

84.3
1
ArcelorMittal Baosteel Group Neue Erzfeinde. In Wirtschftswoche (2010), No. 21, p.154.
POSCO Nippon Steel 2
Raw Materials Group estimates the iron ore projects for 2009-2011 in Oceania at
JFE Other about 230 m tonnes, with 110 m tonnes being considered proven deposits, in
Source: WSA 4 Africa about 50 m tonnes, of which some 20 m proven.

2 July 29, 2010

Turbulence in the steel market

Iron ore: Spot vs. forward ThyssenKrupp has intensified cooperation with its main supplier,
prices
Iron ore 63.5% Fe, USD/t Vale, which holds stakes in ThyssenKrupp’s steel plants.
220 To ensure that there is no increase in speculative pressures and that
200
180 iron ore prices do not decouple from “real business”, the iron ore
160 market must become more liquid and more transparent. If a
140
120 representative market price for iron ore were to emerge in this way,
100 it would give steelmakers scope to guard against price risks via
80
60 hedging.
40
20 Steel market development is unclear
0
04 05 06 07 08 09 10 Steel production is mainly concentrated in several countries: China,
the EU-27, Japan, North America and Russia produced 77% of
Spot price China
Contract price cfr* AU-CN world output in 2009. China’s share increased during the economic
Contract price fob* AU crisis in particular and came to 47% in 2009. Global steel production
*cfr: cost & freight; fob: free on board
declined in 2008 and 2009 because of the crisis. However, China
Sources: Metal Bulletin, The Steel Index 5 continued to boost output also during the crisis. By contrast, North
America and Europe in particular were compelled to curtail
China driving global steel production substantially, with it decreasing in 2009 by over 40% in
production North America versus 2007 and by 34% across Europe. Italy was
Tonnes (bn)
the worst performer with a 37% drop, while Spain suffered a decline
1.4 of “only” 24%. Since the first half of 2010, European crude steel
Tausende

1.2 output has rebounded. But since inventories are being run up again,
1.0
0.8
it is difficult to interpret real demand correctly.
0.6 Two different trends are to be seen in global industrial production.
0.4
0.2
Industrial activity in China and India is on a pronounced uptrend,
0.0 while production in Europe has recently started to recover after
00 01 02 03 04 05 06 07 08 09 plunging in 2008 and 2009. Evidence can be seen here of the close
3
correlation between crude steel and industrial production. European
Other Russia
North America Japan
makers have benefited from the foreign exchange developments of
EU-27 China the past few months. Taking the benchmark product hot-rolled wide
Source: WSA 6 strip as an example, it can be seen that 65% of the price increase is
attributable to the falling EUR/USD exchange rate and merely 35%
Steel cycle not yet back to an effective price hike.
to normal
Real output, change % yoy, The steelmakers are currently fighting a losing battle against the
Q1 2010 over Q1 2008 radical changes in the iron ore market such as the shift from bilateral
North America contracts to exchange-based trading. They do not consider
EU-27 themselves to be in a position to shoulder the billions in expense
CIS triggered by the changes in iron ore prices alone and are responding
World ex. China
Japan by hiking steel prices and shortening contract periods with their
Germany customers.
World
India Price hikes being passed on to manufacturing industry
China
As the higher prices and risks in the iron ore market are being
-30 -20 -10 0 10 20 30 passed on to users, the entire value chain is being impacted by the
Sources: WSA, DB Research 7
changes. Steel processors have to readjust their operations to
shorter production runs and greater price fluctuations. As long as the
Industrial production rising euro is weak, steel user industries in the EU derive fewer benefits
2005=100, moving average from imports. This intensifies the sector’s dependence on domestic
120 220 steelmakers. Germany’s steelmakers thus increased their prices
115 210 again as of July 1, after having already boosted them as of April 1.
110 200
105 190 This has nearly returned the price of the benchmark product hot-
100 180 rolled wide strip to the pre-crisis level.
95 170
90 160 The steel-processing industry considers itself disadvantaged in
85 150 contract negotiations with the major steel producers. First, these
80 140 market participants are usually small and medium-sized enterprises
08 09 10
EU DE 3
US CN (right) See Perlitz (2009). EU steel industry. Deutsche Bank Research. EU Monitor 69.
Frankfurt am Main.
Sources: OECD, China NBS, DB Research 8

July 29, 2010 3

 Research Briefing

that are said to lack the bargaining power required to have their
Steel price demands accommodated by the steelmakers. Second, they say
Hot-rolled wide strip, USD/t there are not enough ways to shore up their operations. Most steel
800
750 products are not sold on exchanges. The non-existence of indices
700 for all types of steel and the small number of steel derivatives result
650 in a dearth of price-hedging instruments. This is why the
600
550
Wirtschaftsverband Stahl- und Metallverarbeitung (WSM),
500 Germany’s steel and metalworking trade association, has called for
450 a hedging mechanism for price fluctuations at the beginning of the
400 value chain, i.e. iron ore hedging. Long-term contracts with users
Dec 08 Jun 09 Dec 09 Jun 10 and price escalator clauses are possible alternatives.
US
Steel-processing industries on an upswing
Northern Europe
The key steel-processing sectors in Europe are the construction,
China, exports to Europe
mechanical engineering and automotive industries. Steel pipe,
Source: The Steel Index 9 structural steel and metal products account for about 12% of the
market. A look at the three most important European user industries
Slight recovery on the shows the sharp fall in production in 2009. These industries are
horizon currently staging a recovery. The business climate index for steel
EU, % yoy, Steel Weighted Industrial processors has already nearly returned to the pre-crisis level.
Production Index
15 The key steel processors say that order intake passed the trough of
10 the crisis in 2009. Output in the mechanical engineering and auto
5 industries is already on an upswing. If demand from abroad
0
continues to pick up, it will probably be easier for the steel
-5
-10 processors to pass on price hikes to their customers. However,
-15 ways to hedge against price fluctuations in the steel market are
-20 needed urgently so that the steel-processing industries can be
-25 guaranteed sustainable planning certainty in the long run.
-30
08 09 10 11 Outlook and conclusion
Structural engineering Specialisation on customer-specific products with exclusive know-
Mechanical engineering how slightly eases the pressure on Germany’s steel-producing
Auto industry industry, since the user industries are not able to switch
Source: Eurofer 10 manufacturer just like that.
As a result of higher steel prices, consumer goods are also set to
Increased order intake become more expensive. Since steel products are directly or
Germany, incoming orders, 2005=100 indirectly used for many everyday objects, this will lead to an
increasing price burden on consumers. Nonetheless, following the
150
huge price hikes on iron ore and steel in the first four months of this
140
year, the prices of iron ore and semi-finished and finished products
130
have already started to decline. Even so, Europe’s steel producers
120
110
will seek to push through their envisioned price hikes again in the
100
third quarter.
90 All in all, the European steel industry is poised to benefit from the
80 recovery of the world economy. We expect Germany’s steel industry
70 to post 35% yoy growth in 2010. Steel prices follow a cyclical
07 08 09 10 pattern, though. If the steel cycle turns downward, the pressure
brought to bear by the iron ore producers will ease, allowing spot
Mechanical engineering
Other metal goods and forward steel prices to fall again.
Structural and civil engineering Lisa Fey (+49 69 910-31875, oliver.rakau@db.com)
Motor vehicles and vehicle parts
Metal products
Source: German Federal Statistical Office 11

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Turbulence in the steel market

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