WRAPUP 1-China rejects iron ore deal, benchmark in doubt
* China's CISA poised to reject 33 pct iron ore price cut
* POSCO, No. 4 steelmaker, set to accept Rio, Nippon deal
* Analysts divided: will benchmark system bend or break?
* BHP boss warns Chinese demand inflated on stockbuilding
By Alfred Cang and Miyoung Kim
SHANGHAI/SEOUL, May 27 (Reuters) - China rejected on Wednesday a 33 percent cut in iron ore prices agreed a day ago by Japanese steelmakers, while No.4 global mill POSCO prepared to accept the deal, highlighting the growing schism that has emerged in a single benchmark system.
While both moves were widely expected, they emphasise the rising strain on the iron ore market's 40-year-old annual pricing system, which has begun to fray as more Chinese mills and big miners tentatively embrace a shift toward market pricing that would better reflect fundamentals and allow them to hedge costs.
China's insistence on a big cut of more than 40 percent -- effectively reversing last year's surge after six years of gains -- threatens to scupper the system, which would normally dictate that Tuesday's deal between Rio Tinto (RIO.L) (RIO.AX) and Nippon Steel (5401.T) sets the basis price for the global industry.
South Korea's POSCO (005490.KS) will accept the same deal, sources said on Wednesday, following its Japanese peers as is the usual practice, but undercutting Chinese steelmakers who are looking for allies to hold out for cheaper rates. [ID:nSEO273431]
The focus is now on whether China -- whose iron ore imports have more than quadrupled since 2002, when prices rose by almost the same -- holds the line at the risk of being forced to buy its imports on the spot market, or strikes a compromise that leaves the annual benchmark system intact for another year.
"The acceptance of the reference price in China remains the main uncertainty and in this respect the settlement has indeed surprised us and will be a test to the benchmark mechanism," Credit Suisse analyst Roger Downey said.
Even if Asian mills stick to the traditional benchmark, China's absence will seriously weaken the system. [ID:nSP279084]
An industry source said the China Iron and Steel Association, the industry group that represents the country's major mills, will issue a statement on the rejection as soon as Wednesday and say it plans to continue negotiating. [ID:nPEK276584]
The chief executive of BHP, which has led miners' move to switch to the spot market, on Wednesday appeared to be ready to offer a compromise, saying China's demand may not be sustainable and the picture for global demand was also unclear. [ID:nSYD62764]
"We have some residual concern in the very short term that there may have been some overbuying in anticipation of the stimulus package, which may have led to some stockbuild ahead of real demand," he told a conference on Wednesday.
"Importantly, in the medium term we don't expect a sharp rebound in overall economic activity; in fact, we probably believe that economic recovery will be both slow and protracted." Despite Chinese mills' initial alarm and the growing ranks of rivals conceding to Rio's price, analysts expect them to continue seeking an even bigger cut because they are not under great pressure, since China is awash with iron ore stockpiles after importing record amounts of ore for three months running.
CHEAPER ON THE SPOT
China is now weighing whether it is better to accept the deal to secure stable long-term supply of iron ore or switch to spot markets which offer better pricing to benchmark deals, sacrificing the supply security that underpins annual deals.
Rio's settlement of 97 U.S. cents per dry metric tonne unit is equivalent to $61 a tonne, while spot Australian fines are sold at a cheaper $53 a tonne in China, traders said.
Many analysts say China, which depends on imports more than ever due to falling domestic production from high-cost mines, could find the logistics challenging for a complete switch to the spot market, besides running the risk of greater price volatility for its mills.
Chinese mills may adopt a hybrid system, which could, for example, allow them to take a bigger 40 percent cut, but if the spot market moves above a certain threshold the discount is reduced. For a scenarios of what Chinese mills face, [ID:nSP279084]
"Ensuring security of supply by following the benchmark might now makes more sense than risking full exposure to the spot market," Goldman Sachs JBWere analyst Malcolm Southwood said.
One Chinese steel executive said the Chinese mill keenest on benchmark pricing was national champion Baosteel (600019.SS), which this year yielded to CISA its traditional role of leading the talks with miners Rio, its Anglo-Australian rival BHP Billiton (BHP.AX) (BLT.L) and Vale (VALE5.SA) of Brazil.
CISA, which has stressed the need to reduce China's massive steel overcapacity, may want to spend more time to balance the pros and cons of switching to a more flexible system, favoured by small-sized mills, away from the benchmark system.
The cloudy outlook for China's economy has worsened the deadlock with iron ore mines, since both sides can call on data which shows either a massive oversupply of iron ore or a healthy market that is recovering well from a dip a few months ago.
"For this year and next, supply of iron ore will outstrip demand and nothing bad will happen if the Chinese side doesn't sign anything," said Zhang Changan, consultant with World Steel Dynamics in Beijing, who expects China to hold to its original demands.
But the Goldman Sachs analyst sounded a note of caution.
"Certainly we find it hard to envisage the miners conceding a larger contract price fall to the Chinese given that the current robustness of steel production in China compared with Japan," said Southwood. (Additional reporting by Tom Miles in SHANGHAI; Editing by Sambit Mohanty)
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