For the past 40 years, the price of iron ore has been set annually in a negotiated deal between miners and buyers. Typically, the first large customer to cut a deal with a miner set the precedent for all the rest. The deal fixed the price for iron ore for the following twelve months, completely ignoring changes in supply or demand.

Beginning this year, the three largest iron ore miners are changing the rules of the game, seeking to negotiate contracts quarterly instead of annually and taking into account spot prices that fluctuate more as supply and demand shift. The three miners that produce about two-thirds of the world’s supply of iron are Vale S.A. (VALE), BHP Billiton (BHP), and Rio Tinto (RTP).

Iron ore sold for about $68/metric ton in 2009, down from about $95/metric ton in 2008. That drop hit miners hard, and the uptick in the global economy which is increasing the demand for steel has given the miners the confidence to demand more for their iron ore.

Vale recently negotiated a contract with Japan’s Sumitomo Metal Industries that nearly doubles the price beginning on April 1st. BHP Billiton has not given any specifics, but has said that it has moved a “significant number” of customers to the new pricing scheme. The price for the quarter beginning April 1st could be as high as $120/metric ton.

The world’s largest buyer of iron ore is China, and the Chinese are not happy about the new regime. But Chinese steelmakers have bought iron ore on the spot market for the past year, and it is likely that the Chinese will eventually accept the new pricing scheme rather than buy on the spot market. For now, though, the Chinese are importing more iron ore from India, which is having some fallout in the shipping business.

India’s ports are too small to accommodate so-called capesize cargo ships, the largest on the world’s seas and the most popular with iron ore shippers. Shippers are required to move down in size to the panamax-size ships, which are smaller. Dayrates for panamax class ships have now risen above dayrates for the bigger capesize ships, a phenomenon last seen at the end of 2008 when the global financial system appeared to be on the verge of total collapse.

This change in ship size will affect dry-bulk carriers like Genco Shipping & Trading (GNK), Diana Shipping (DSX), DryShips (DRYS), and others which haul a lot of iron ore. Shipping analysts believe that the fixed-price contract for iron ore is better for the shipping industry, but they seem reconciled to the fact that spot pricing is the new way.

That doesn’t mean they, or any other business downstream of the miners likes the deal. Aside from the Chinese, the Europeans are yelling the loudest about the change. Steelmakers and automakers in Europe are demanding that EU regulators investigate what the automakers have called “distortive developments” resulting from the new iron ore pricing scheme.

The argument that the miners are engaging in unfair trade practices is a bit disingenuous. When the benchmarking contracts that favored steelmakers were the standard, the miners didn’t charge the steelmakers with collusion.

And the ripples don’t stop there. The spot market for iron ore is just barely in development, and, therefore, barely liquid. The derivatives market for iron ore swaps is currently estimated to cover about 36 million metric tons of production, about 4% of total global production. Contrast that with the market for crude oil, where derivative contracts exceed physical product by anywhere from 3 to 10 times. Steel producers have very little experience in these markets and there will be some rocky reefs ahead.

The big winners, for now, appears to be Cliffs Natural Resources (CLF) and, oddly enough, the US steel industry. Cliffs is the last of the major North American iron ore miners and it has seen its share price rise almost 60% since the beginning of 2010.

Because the ore price hikes affect only seaborne cargoes, US steelmakers US Steel (X), Nucor (NUE), AK Steel (AKS), and ArcelorMittal (MT) are largely able to avoid the price rises because they either own their own iron ore mines or they can buy from Cliffs.

The battle over iron ore pricing is not over yet. But for now, the miners have the advantage.

Paul Ausick

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