--Clyde Russell is a Reuters columnist. The views expressed are his own.--
By Clyde Russell
LAUNCESTON, Australia, May 26 (Reuters) - Iron ore swaps traded in Singapore are suggesting that the worst may be over for the steelmaking ingredient, but futures in the Chinese city of Dalian point to further price weakness.
Both can’t be correct, but the divergence of the two contracts does raise the question as to which group of investors has a more accurate gauge on the current balance of risks.
The Singapore Exchange (SGX) iron ore swaps <0#SGXIOS:> tend to be favoured by miners and traders, while the Dalian Commodity Exchange (DCE) futures <0#DCIO:> are mainly used by Chinese steel mills and domestic investors.
The SGX iron ore swaps curve tends to move into backwardation prior to a price decline, reversing the process ahead of a rally by moving into contango.
The shape of the current SGX curve is extremely mild backwardation from the second month onwards, with the second-month contract priced at $97.25 a tonne early on Monday, the six-month at $96.58 and the 12-month at $97.
Spot iron ore .IO62-CNI=SI has been on a downtrend since Dec. 4 last year, when it fetched $139.70 a tonne. At that time the SGX curve was steeply in backwardation, with the second-month contract at $137.56, the six-month at $127.50 and the 12-month at $118.88.
The curve was last in significant contango in early June 2013, just as iron ore started a rally that saw it move from about $110 a tonne to a peak of $142.80 on Aug. 14 of that year.
So, the current shape of the SGX curve doesn’t yet imply an imminent rally as it is still backwardated, even if ever so slightly, but it also doesn’t imply further price declines given the backwardation has almost disappeared in recent weeks.
The DCE iron ore contract, launched in October last year, has a shorter history, but it has quickly attracted volumes and the second-month future’s open interest was 2,108 lots as of May 23.
Over its history it has tended to trade mainly in backwardation, but this is hardly surprising given that spot iron ore has been declining since early December last year.
Currently the DCE curve is steeply backwardated at the front end, easing slightly further out.
The backwardation at the front end of the curve is currently the steepest in the short history of the product, illustrating the point that DCE investors are probably more bearish on iron ore now than at any time during the past six months.
The second-month contract was at 769 yuan ($123.43) a tonne on May 23, a premium of 8.7 percent to the six-month.
This compares to a premium of 2.5 percent that prevailed on Oct. 29 last year, just ahead of a mild rally in spot iron ore that saw the price go from $131.30 a tonne to $139.70 on Dec. 4.
The only other time in the life of the DCE contract that there has been a rally in iron ore prices was from March 10 to April 9, and just prior to this period the second-month future was at a premium of just 1.2 percent to the six-month.
The DCE curve implies that further iron ore price weakness is likely in the coming months.
The question is how to resolve the different signals from the two main markets for iron ore swaps and futures.
It’s possible that investors using the SGX contracts are more likely to respond to short-term price signals and news events.
An example would be the recent focus on the possible disruption of exports from Australia’s Port Hedland, with tugboat workers threatening to strike at the harbour, which handles about half of the shipments from the world’s biggest iron ore exporter.
The strike was averted last week when the workers agreed to suspend any action for 30 days to allow for more talks with tugboat operator Teekay Shipping.
News that the flash reading for HSBC’s China Purchasing Managers’ Index rebounded in May, coupled with record iron ore shipments from Australia to China in April may also have contributed to a view that the worst is over for prices.
Chinese domestic investors using the DCE futures may be more likely to focus on the longer-term structural issues facing iron ore demand, such as the downturn in residential construction, weak profitability and over-capacity in steelmaking, and pressure to reduce pollution from coal, the main fuel for blast furnaces.
Both groups of investors are also probably concerned about the impact on prices from rising supply.
Australian exports to China were 47 million tonnes in April, a jump of almost 46 percent on the same month last year.
This shows that the wave of supply from new mines and expansions is starting to hit, with an additional 240 million tonnes of new supply expected to be brought on line this year and next.
This makes the bearish view presented by the DCE futures curve the more likely scenario on a 12-month view.
However, the SGX curve suggests price stability for the next few months, which is possible if China’s seasonal steel demand does pick up for summer and the PMIs confirm a manufacturing recovery is underway. (Editing by Tom Hogue)