The iron ore forward curve has made history in November by recording the longest period of contango* in its brief existence.
On November 1, Platts assessed The Steel Index 62% Fe CFR China swaps in contango from the December strip out to Q2 2018, which has been sustained until now.
Forward curve structure
Unlike many bulk commodities in recent years, iron ore’s forward curve has remained stubbornly backwardated, with prices further down the curve being lower than those at the prompt.
This has puzzled many market observers.
In commodity markets a contango tends to signal supply outweighing demand.
In other major commodities, when supply has patently swamped demand – see Brent crude oil futures roughly between Q3 2014 and Q3 2017 – the forward curve reacted swiftly, moving from backwardation to contango.
In iron ore, though, even in the regular periods where either demand has fallen away or supply has grown acutely, the curve has remained backwardated.
Iron ore seaborne price
It should be stated that today’s market situation in iron ore thoroughly supports a contango structure.
Due to attempts to prevent air quality worsening during the heating season in China, steelmakers in the world’s largest-producing nation are being asked to cut back, particularly in sintering – the process that uses iron ore fines (the product on which derivatives contract prices are based).
S&P Global Platts estimates that these cuts between mid-November and end-March 2018 could amount to 33 million metric tonnes of steel production removed.
In addition to these cuts, iron ore output among major producers surged during Q3, with some achieving record production. Even those reporting weak quarters held overall output guidance unchanged.
It is no surprise then that the contango started to open up on the Q1-Q2 spread for swaps contracts, which are largely cleared via the Singapore Exchange (SGX). The settlement benchmark for this swaps contract is Platts’ TSI 62% Fe CFR China index.
Q1 2018 represents the period of ongoing steel production cuts in China, while Q2 is seasonally a strong period for steel demand, explaining the contango structure for this part of the curve, before a backwardation returns between Q2 and Q3 2018.
It took a few days for the prompt months (currently, that’s realistically November-December-January) to catch up, though, before the contango in the prompt deepened.
This is a little more surprising, given the prompt months are the most liquid part of the curve and therefore generally the most reactive to changes in fundamentals.
Why there was a lag is a really interesting question, which market participants are still struggling to answer.
An unsatisfying, but common, response is that there was a “psychological block” for market participants trading prompt month swaps. Because the contract had basically forever been in backwardation, it took some time for systems to reset and traders to start getting used to the idea of a contango.
When talking about the reasons why the iron ore forward curve has been backwardated for so long, it is worth separating the reasons for the prompt backwardation from the far-dated backwardation. The latter tends to represent new projects coming online or the cost curve and current understanding of exploration & production.
Some market observers believe the backwardation in the prompt focused on the hand-to-mouth procurement strategies of Chinese end-user steel mills or a lack of suppliers hedging through the swaps market.
Others posit that mined products’ “natural” state is backwardated due to the lengthy logistical chain before the good is put to use. In iron ore this lengthy supply chain has been cut to ribbons in recent years by a build in port stocks in China and stockpiles in major supply regions’ terminals as well.
In fact, the contango seen in the swaps forward curve is also now visible in the physical forward structure as well. Iron ore port stocks in China are bought for prompt delivery (often for truck loading on the same day), while seaborne material arrives in China 2-8 weeks ahead of the date of sale.
Therefore, when comparing the port stock prices to the seaborne prices, one can observe the time structure in the physical iron ore fines market, as seen in the below graph.
Port stocks vs. seaborne price
Platts IOPEX port stocks index was assessed negative to the seaborne IODEX on November 6, indicating a contango in the physical forward structure.
There are many reasons given for the backwardation further down the curve.
1) Due to financial constraints of end-users in China, the lack of strong hands in a natural position to buy long-dated positions has left relatively more strength at the prompt.
2) There is also a longstanding received-wisdom in the iron ore market that low-cost future supply growth would displace higher-cost production, which supports a backwardated structure.
In fact, this is still the case today: for later calendar years, the forward curve is still in backwardation.
However, miners have been engaging in cost-cutting for at least two years due to the lower flat price environment; while they have been successful, that success is partially due to favorable forex and energy costs.
Some have already turned to hedging via the swaps contracts, while others are putting plans in place to start, or to opportunistically hedge part of their sales book during periods of price spikes.
Liquidity helps: 2016 volumes on the SGX contract grew to nearly 1.7 billion mt from just over 1 billion mt the previous year. Traded volumes are on track to grow further in 2017.
In addition to the iron ore fines swaps contract, SGX’s lump premium contract posted record monthly trade volumes in Q3 2017 thanks to increased volatility and wider participation.
The next question is whether the contango in today’s forward curve is here to stay. The answer will depend largely on the extent of China’s steel production cuts in Q4 2017/Q1 2018.
“All the physical players are watching China’s daily crude steel output,” one industry participant said. “Unless the [output] cuts fall way short of predictions, the contango looks here to stay.”
All eyes are on mid-November data, then, to see how production cuts play out in reported figures.