Iron ore’s growing appeal: investor participation and market development

Once in a generation a new graduate joins the elite circle of globally recognized and traded commodities. Julien Hall, head of metals pricing, APAC at S&P Global Platts, and Fiona Boal, head of commodities at S&P Dow Jones Indices, look at the interplay between physical and financial iron ore markets.

Now widely viewed as the second most important commodity behind oil, the evolution of iron ore has mirrored the transformation of China. One of the least volatile commodities in 2020, iron ore has outperformed metals and mining equities, which over the last seven years are roughly flat, while the S&P GSCI Iron Ore Index has more than tripled.

The emergence of iron ore has been a rapid one by commodity market standards. Just 10 years ago, the magnetic red dirt was an opaque market with contract negotiations taking place annually in smoke-filled rooms in Japan and later China. The market now has two liquid futures markets on the Singapore Exchange (SGX) and Dalian Commodity Exchange (DCE). These financial markets are trading 1.2 times and 20 times physical seaborne market volumes, respectively.

The iron ore market has several characteristics that make it distinctive as an investable asset; supply is concentrated in a handful of geographic regions, notably Brazil and Australia and held by a small number of players. Global demand is dictated by one major end-user, China.

Both supply and demand are subject to shocks caused by geopolitical events, unforeseen natural disasters and policy decisions, as well as the actions of individual asset owners. S&P Global Platts IODEX, the main prevailing industry price benchmark, which represents medium-grade iron ore with 62% iron content, has once again spiked, flirting around the $100/mt driven by strong demand-side fundamentals in China with rising steel prices and strong steelmaker profit margins.

Meanwhile, supply remains tight, particularly out of Brazil where weekly export volumes have fallen to 4.7 million mt and port inventories in China have fallen around 10% to around 110 million. Against this backdrop, and potentially creating further upside, China laid out its plans to issue Yuan 3.75 trillion ($526.8 billion) of new local government special bonds which is expected to boost infrastructure construction.

The unique characteristics of iron ore present tactical opportunities for investors, as a liquid and easily accessible proxy for Chinese economic growth or, more specifically, the performance of the Chinese manufacturing and infrastructure sectors.

Historically, most market participants gained exposure to iron ore through buying the stock of metals and mining companies. There are some difficulties that arise by taking this path. Only a few companies are focused on iron ore due to the high costs associated with producing it. These companies are not pure-play iron ore equities, with the percentage dedicated to iron ranging from 30% to 60% of their businesses.

The creation of the iron ore futures by SGX and DCE and the S&P GSCI Iron Ore index has allowed market participants to gain direct exposure to iron ore, and improved liquidity and price transparency in derivative markets.

The physical iron ore market has become increasingly transparent over recent years, spot market activity is deep, with transactions accounting for 12%-15% of total market size, according to S&P Global Platts price reporting data.

Bid-offer spreads in the physical market have tightened to around 50 cents at the time of assessment for the mainstream brands of iron ore. While this isn’t yet at the 1 cent/barrel typically seen at the close for the Platts Dated Brent assessment, it highlights the tremendous change iron ore has seen in the last decade.

But in several ways, iron ore still remains a very traditional physical supply chain, both in its inherent setup and attitudes. The length of trading chains, often seen as a barometer of commoditization and market maturity, is still rather short in iron ore, with most cargoes only changing hands once or twice, compared with up to 15 times in some energy markets.

Further, a reluctance of iron ore producers to openly bid or offer material has stifled the evolution towards a more efficient, liquid and transparent market, as occurs in other more mature commodity markets such as oil. This hesitancy is said to stem from fears of an outcry from steelmakers claiming this could in some way amount to abuse by the miners. Yet, it is worth noting that Chinese steelmakers routinely openly sell in the market.

In commodity markets the role of financial participants is to provide liquidity and warehouse risk. As investors increasingly look to incorporate commodities in their systematic investment strategies, the iron ore market will undoubtedly attract more attention from financial players. On the whole, this attention should be welcome.
Source: Platts