December 4, 2012 / 12:36 AM / in 5 years

Brazil's Vale sees derivatives market developing in iron ore

* Major iron ore derivatives market seen taking shape

* Volatile prices pressure producer-consumer deals

By Barani Krishnan

NEW YORK, Dec 3 (Reuters) - Brazil’s Vale SA, the world’s second largest mining firm, said on Monday it expects a huge derivatives market in iron ore to eventually take shape as players seek hedging instruments to minimize risk from increasingly volatile prices.

“I believe a big financialization of the iron ore market will be inevitable,” Jose Carlos Martins, who runs the iron ore business for Vale - the world’s single largest producer of the commodity - said at a news conference in New York.

The price of iron ore , a key ingredient for steel, fell by a third in China’s spot market in August before recouping all of its losses over three months.

The stormy price action was a result of a supply deluge, followed by a surge in demand in China, the world’s largest market for iron ore.

“The Chinese have a very big risk appetite towards iron ore because they consume 65 percent of production. Other clients of iron ore who cannot work with this volatility will have to resort to financial instruments to guarantee market stability,” Martins said.

“So, we see an increasing trend in the market to use more financial instruments or derivatives to try and hedge away risk. This will be much bigger in the European and Japanese markets.”

The spot price of iron ore, now hovering around $115 a tonne, is still below levels that some producers find profitable. In August, the price fell under $89, below the production cost for at least 30 percent of the world’s producers. Vale forecast a price range of $110 to $140 in 2013.

For decades, iron ore sales were decided by an annual benchmark price system negotiated between producers and consumers, with contracts for as many as 10 to 15 years common in a market with predictable price growth, Martins said.

The advent of huge supply-demand from China’s booming economy brought unprecedented volatility to the commodity, generating a spot market for iron ore that put pressure on producer-consumer negotiated contracts.

China’s top economic planner said in October that the country should move ahead with plans to launch futures contracts to help firms buying the steelmaking raw material manage price risks. Three exchanges - two in India and one in Singapore - are currently trading iron ore futures although liquidity has been thin since trading kicked off last year.

Vale has tried to preserve the negotiated contracts system with its customers by making price adjustments every quarter, but even that seemed inadequate at times in a gyrating spot market, Martins said.

“We believe the future of iron ore will be on deals based more than ever on the spot market, with contract terms of one to three years. Clients will not want long-term contracts,” Martins said.

While Vale was closely monitoring the market’s move towards greater securitization, it was not playing any leading role in bringing about a change, Chief Executive Murrilo Ferreira said.

“There is no study or plans at Vale to be an active player in the iron ore derivatives market,” Ferreira said.

“The pricing system or levels with which clients became comfortable to hedge is not a process that happens overnight. I saw it in copper, I saw it in aluminium. It’s really a long-term process.”

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