Iron ore futures an accurate guide

Investing Guide at Deep Blue Group Publications LLC - Fledgling Chinese iron ore futures traded by speculators and small-time industry players are giving accurate predictions of moves in the iron ore spot price, which has become increasingly important to the health of ­Australia’s biggest miners and national export revenue.

Analysis by the The Australian shows price moves in the five-month-old Dalian Commodities Exchange iron ore futures price have become highly correlated to the overnight moves in the spot price, which Platts puts out well after market using private information from hundreds of physical iron ore traders.

The relationship was starkly illustrated when, overnight on March 10, the iron ore price had its biggest fall in years.

That day, before the price fall was announced, Dalian futures traders -- obviously plugged into physical price moves yet to be ­revealed to the market -- sold off hard.

The Dalian move contributed to a $16 billion rout on the Australian Stock Exchange, despite the official extent of the iron ore spot price move not being known.

The futures gave a real-time indication of the big fall coming in the benchmark iron ore price index well before the index price was printed at the end of the Asian trading day.

The iron ore price is becoming a more important factor for mining stocks such as BHP Billiton, Rio Tinto and Fortescue Metals Group, completing huge expansions in Western Australia.

The expansions mean iron ore is now easily Australia’s biggest export, so the price moves can have a big impact on royalties and taxes.

IG Markets chief market strategist Chris Weston said the futures became a valuable source of trading information on March 10, when BHP, Rio and Fortescue were sold off.

“I’m not surprised the correlation is high,” Mr Weston said.

“Dalian futures are a good ­barometer of overnight direction. However, the moves can be much more pronounced than those of the spot price.”

Correlation analysis shows the most-traded Dalian iron ore futures contract this month and Platts’ The Steel Index iron ore price had a correlation coefficient of 0.82 -- which in statistical terms makes them highly correlated (a coefficient of 1 means they always move in unison).

Iron ore pricing has been rapidly evolving in the past five years since former BHP chief Marius Kloppers engineered a move away from a 40-year-old system of annually negotiating prices to one based on spot market trades.

The big miners now sell most of their iron ore based on movements in a spot price index while futures and swap contracts have sprung up on various exchanges.

Of the exchange-traded iron ore derivatives, it is the yuan-priced, 100-tonne Dalian futures contract -- the only physically settled futures in the world -- now creating the most waves.

Volumes of the futures, which only started trading in October, surged this month as iron ore ­prices began sliding, with speculators and smaller commercial players attracted by increased price volatility.

On March 24, a record 1.3 million of the most-traded contract (iron ore for September delivery) changed hands, which is more than a fourfold increase on the pre-March record.

The exchange, in the port city of Dalian, had another breakthrough this month when the first futures contract was physically settled.

To do so, a trading company delivered 10,000 tonnes of Australian iron ore, at the contract’s specified grade of 61.9 per cent, to a steel company at the port of Lianyungang Australia’s big iron ore miners and the big Chinese steel mills are not trading on the exchange and the ability of the futures to move iron ore prices has been limited to its effect on market sentiment among traders. The benchmark iron ore price compiled by The Steel Index is arrived at after the Chinese trading day (and well after Australian markets close).

Physical settlement through the actual delivery of iron ore will be a rare occurrence, where a contract to buy can be cancelled by a market purchase of a contract to sell.

But the option of settlement ensures futures prices do not stray too far from physical prices.