Iron Ore Sea Change to Hit Dry Bulk

NEW YORK (TheStreet) -- The ongoing price negotiations between China's state-owned steel industry and its iron-ore suppliers has already had serious ramifications on dry-bulk shipping companies.

At stake in the negotiations is not only what price China's buyers will pay for iron ore, but the very system by which the global steel and mining industries have conducted business for the last 40 years.

Traditionally, steelmakers in China, Korea, Japan and Europe have acquired their seaborne iron-ore after striking an agreement with miners that would lock in prices for that year. Some trade would then occur on the spot market, but the vast majority of ocean-going ore was bought and sold under an annual contracts.

Now, however, led by BHP Billiton ( BHP) especially, the world's biggest iron ore producers (Brazil's Vale ( VALE) is the biggest, Rio Tinto ( RTP) is No. 3 behind BHP) want to upend the annual system and move to a shorter-term, variable pricing regime. This would likely mean quarterly contracts, though some speculation has indicated a move toward an all-spot market, just as most commodities are traded and priced.

Altogether, Chinese steelmakers produce more than half the steel that's manufactured each year globally and, for this reason, they've argued that they deserve a discount.

Be that as it may, after 2009's pricing talks collapsed in acrimony, China's steel mills have been forced to buy their ore on the spot market for the past year. Traditionally, only about 10% of the world's ore has been traded on the spot market. But since last April that percentage has surged to 50% (and as high as 70%).

Most steelmakers hate the spot market and, in China and Europe, they've complained loudly about the move away from contract pricing. The miners, meanwhile, have basked in widening profits as prices for the crucial steel feedstock have risen sharply since last year.

That very rise has fueled speculation that the next benchmark pricing settlement for 2010 will double from last year and approach 2008 levels, a remarkable turnaround for a commodity so linked to economic expansion. Japan's steel industry reportedly struck an agreement with Vale over the weekend for a 100% price increase. Rumors swirled Monday that China had agreed to the same.

So what does this all mean for the dry-bulk shipping companies that put the "seaborne" in "iron ore?" Everyone agrees that the impact will be serious, especially on those dry-bulk carriers with heavy exposure to the ore trade: Genco Shipping & Trading ( GNK), Diana Shipping ( DSX), DryShips ( DRYS), Navios Maritime Holdings ( NM), Eagle Bulk Shipping ( EGLE), Excel Maritime ( EXM).

For one thing, as pricing talks have dragged on between the miners and their iron-ore customers in China, both sides have been trying to influence the iron-ore spot market to gain leverage -- or, at least, the evidence, plus a cynical worldview, suggests that this might be so. "In any negotiation, there's gamesmanship that goes on on both sides," said one stock analyst. "So why would that not be happening right now?"

Perhaps miners are hesitating to put iron ore onto the market in an attempt to drive spot prices higher. Perhaps China is purposefully hesitating to book iron-ore cargoes out of places such as Australia and Brazil in a bid to weaken prices on the spot market.

Whatever the case, between December 2009 and February, China bought more iron ore from India than it had since the same time last year. A pattern has developed: During the period of price-negotiation tension between miners and Chinese steelmakers, China goes to India for more of its ore. This increases the supply of available ships on the market, since the India-to-China route is far shorter than the Brazil-to-China route.

It also increases the supply of available capesize ships relative to smaller vessels, since India's ports are generally too small to handle capesizes -- the largest bulk carriers on the seas, and thus the world's iron-ore transporter of choice.

Since last week, the going rate for a cargo on a capesize ship was less than that of a much smaller panamax-size vessel. According to the Baltic Exchange, the London ship broker, capesize day rates were about $28,500 on Monday, compared with $30,600 for a panamax. This marks the first time since late 2008 -- when the global financial system and the maritime freight market both collapsed -- that capesize day rates have been cheaper than those for a panamax.

The cape-panamax inversion isn't sustainable, of course. In the long run, what matters most for shippers is whether the iron-ore pricing status quo remains in place, or whether some kind of variable system supplants it.

Shipping experts appear to be divided on this. Certainly a pure spot-pricing model would render dry-bulk shipping rates much more volatile. The Baltic Dry Index, a measure of spot rates across vessels sizes, would be much more closely linked to iron ore prices.

Some observers -- including Omar Nokta, the shipping analyst at Dahlman Rose -- believe shippers would benefit far more from a fixed pricing model as opposed to a spot-market one.

The thesis runs thusly: If steel demand is strong and prices are rising, as they have been recently, steelmakers want their ore, not matter the cost, and this pushes freight rates higher. If all iron ore was bought and sold on the spot market, miners could hike their prices for the raw material almost instantly, adjusting for customer demand and squeezing out the gains just made by the shipping companies.

"We believe the shift towards a spot-priced iron ore system will continue to benefit miners at the expense of shipowners," Nokta wrote in a note to clients earlier this year. "And we look for the outcome of the 2010 iron ore negotiations to be the most important factor in determining the potential for freight rates this year."

-- Written by Scott Eden in New York

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Scott Eden has covered business -- both large and small -- for more than a decade. Prior to joining TheStreet.com, he worked as a features reporter for Dealmaker and Trader Monthly magazines. Before that, he wrote for the Chicago Reader, that city's weekly paper. Early in his career, he was a staff reporter at the Dow Jones News Service. His reporting has appeared in The Wall Street Journal, Men's Journal, the St. Petersburg (Fla.) Times, and the Believer magazine, among other publications. He's also the author of Touchdown Jesus (Simon & Schuster, 2005), a nonfiction book about Notre Dame football fans and the business and politics of big-time college sports. He has degrees from Notre Dame and Washington University in St. Louis.

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