UPDATE 2-BHP offers iron ore indices to China steelmakers

* BHP offers China steelmakers iron ore index pricing scheme

* China seeks annual contract; adamant on 40-50 pct price cut (Updates with quotes, details)

By Nick Trevethan

SINGAPORE, June 4 (Reuters) - BHP Billiton (BHP.AX)(BLT.L) is trying to tempt China's steel sector with index-linked prices for iron ore, several sources said on Thursday, a ploy that could shatter a traditional annual pricing system that is already under strain.

A source close to BHP and an executive in a state-owned Chinese trading company, neither of whom were authorised to speak to the media, said several small mills had agreed to terms but no big firms had yet signed up.

At stake is how the around $88 billion a year of seaborne iron ore is priced after China's mills rejected a 33 percent cut agreed between their Japanese and South Korea counterparts and BHP rival Rio Tinto (RIO.AX)(RIO.L).

"The Chinese and Australians look like they may be starting to walk the same path -- gravitating towards an index -- which few would have predicted just three years ago," ANZ's senior commodities analyst Mark Pervan said.

"The present contract system has proven inequitable for consumers in the past few years and this year might be bad for producers."

BHP Billiton spokeswoman Samantha Evans declined to comment, citing company policy, but the move would be in line with stated company goals -- BHP's CEO, Marius Kloppers, has said there is a need for more of a market clearing price system or price indexing.

Whether BHP can get the big Chinese mills on board is uncertain.

China Iron and Steel Association, the country's lead negotiator, has repeatedly opposed an iron ore index pricing system, declaring it would make it hard for steelmills to lock in production costs.

Japanese and South Korean steel-makers agreed a 33 percent price cut with Rio Tinto, but that was roundly rejected by CISA, which is demanding a cut of at least 40 percent.

Shen Wenrong, chairman of Jiangsu Shagang Corp, the only privately-owned firm that ranks in China's top five steel mills, said his company had not been in talks with BHP Billiton on the issue and that Chinese mills still wanted a 40-50 percent cut in the benchmark price.

"We say 40 percent, because our basis is 40 percent, but the deal could be 38, 39, 41, 42 percent cut, depending on the negotiation. Nobody can say 40 percent is an absolute figure," Shen told Reuters.

INDICES THE FUTURE

Sources from China's iron ore industry said the deals with the small private mills were based on Platts and Steel Business Briefing reference prices.

There are independent indices offerings from Platts, The Steel Index by Steel Business Briefing and one from Metal Bulletin.

Those indices also form the basis for the recent proliferation of various iron ore swaps contracts, including cleared contracts offered by the Singapore Stock Exchange and LCH.Clearnet in London.

For a factbox on the new era for iron ore contracts, please click: [ID:nSP361332] and for the indices: [ID:nSEO164190]

Every year for the the past four decades, iron ore miners and steelmakers have thrashed out annual contract prices.

Until recently the first settlement constituted a benchmark that the rest of the industry followed, but that has broken down and talks have become more and more bitter to the point now where some in the market are seeking alternatives.

"It's still possible we will see a contract settlement and if we do it will be pretty close, if not the same as the 33 percent agreed with Japan," said BT Financial Group's Sydney-based resource analyst Tim Barker.

But time may be running out.

"Rio have effectively stated that if the contract is not settled by the end of June material will be sold on spot basis. The Chinese know full well that in the long-term they will pay more on a spot basis and prices will be more volatile," Barker said. (Additional reporting by Bruce Hextall in Sydney and Alfred Cang in Shanghai)