Executive Summary
After crude oil, iron ore is the world’s largest traded commodity by both weight and value. At any one point in time, roughly 50% of all global dry bulk shipping capacity is involved in the global steel industry, in particular moving iron ore from where it is mined and refined to where it is smelted into steel. While most steel finds its way into construction, significant amounts are used in manufacturing and other applications, making iron ore an input into a huge portion of global economic activity in general. Recent estimates are that the global iron ore and steel market comprises approximately $2.5tn of activity or 4% of global GDP. As such, iron ore demand, and by extension prices, are a potentially useful leading or coincident indicator for global economic activity, in particular those regions that are building out core infrastructure, such as in much of Asia.
Moreover, due to the changing structure of the global energy markets, including that for crude oil specifically, a strong case can be made that iron ore has now become a more reliable leading indicator for global economic activity than crude oil and, alongside copper, can therefore be a useful trading and hedging tool for any enterprise with a general exposure to the global macroeconomic cycle.
Iron Ore’s Macro Characteristics
Given the size of the global steel market, it follows that iron ore prices have a relationship with the global macroeconomic cycle, including that for Chinese activity specifically. Indeed, it is estimated that China accounts for 36% of the steel industry’s annual contribution to global GDP, whereas the US accounts for only 11%, and Japan 9%.
As an example, over the past decade iron ore prices have tended to move with Chinese electricity production – a reasonable proxy for industrial activity generally (Chart 1). Since 2014, the coincident correlation of iron ore prices with electricity production has been around 45%, slightly below those of crude oil and copper at 65% and 50%, respectively. However, when lagged by six months, iron ore shows a correlation of 55% vs 45% for crude and 30% for copper. Hence, iron ore prices have emerged as the best leading indicator of the three.
There could be several reasons for iron ore’s leading properties, but the most important is probably that steel production is associated with construction, infrastructure and capital goods investment. These are highly multiplicative factors for an economy generally, all stimulating in turn other sources of economic demand. Copper demand tends to be concentrated proportionately more in consumer goods, especially electronics, and crude oil demand tends to be coincident with industrial production, rather than a leading indicator as such.
For a more thorough discussion of the evidence of iron ore’s macro properties, please see ‘Using Iron Ore to Track Chinese Growth’.
Who Produces, Who Buys?
The global iron ore market is estimated to be $210bn/yr in size, of which $95bn is exported. This makes it the largest of all the metals by a wide margin and the second largest global commodity market by value. The market for crude oil, the largest of all the global commodities markets, is estimated to be almost $1,000bn (Table 1).
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After crude oil, iron ore is the world’s largest traded commodity by both weight and value. At any one point in time, roughly 50% of all global dry bulk shipping capacity is involved in the global steel industry, in particular moving iron ore from where it is mined and refined to where it is smelted into steel. While most steel finds its way into construction, significant amounts are used in manufacturing and other applications, making iron ore an input into a huge portion of global economic activity in general. Recent estimates are that the global iron ore and steel market comprises approximately $2.5tn of activity or 4% of global GDP. As such, iron ore demand, and by extension prices, are a potentially useful leading or coincident indicator for global economic activity, in particular those regions that are building out core infrastructure, such as in much of Asia.
Moreover, due to the changing structure of the global energy markets, including that for crude oil specifically, a strong case can be made that iron ore has now become a more reliable leading indicator for global economic activity than crude oil and, alongside copper, can therefore be a useful trading and hedging tool for any enterprise with a general exposure to the global macroeconomic cycle.
Iron Ore’s Macro Characteristics
Given the size of the global steel market, it follows that iron ore prices have a relationship with the global macroeconomic cycle, including that for Chinese activity specifically. Indeed, it is estimated that China accounts for 36% of the steel industry’s annual contribution to global GDP, whereas the US accounts for only 11%, and Japan 9%.
Chart 1: Iron Ore Futures Has Become More Closely Tied to China Cycle Over Past Decade |
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As an example, over the past decade iron ore prices have tended to move with Chinese electricity production – a reasonable proxy for industrial activity generally (Chart 1). Since 2014, the coincident correlation of iron ore prices with electricity production has been around 45%, slightly below those of crude oil and copper at 65% and 50%, respectively. However, when lagged by six months, iron ore shows a correlation of 55% vs 45% for crude and 30% for copper. Hence, iron ore prices have emerged as the best leading indicator of the three.
There could be several reasons for iron ore’s leading properties, but the most important is probably that steel production is associated with construction, infrastructure and capital goods investment. These are highly multiplicative factors for an economy generally, all stimulating in turn other sources of economic demand. Copper demand tends to be concentrated proportionately more in consumer goods, especially electronics, and crude oil demand tends to be coincident with industrial production, rather than a leading indicator as such.
For a more thorough discussion of the evidence of iron ore’s macro properties, please see ‘Using Iron Ore to Track Chinese Growth’.
Who Produces, Who Buys?
The global iron ore market is estimated to be $210bn/yr in size, of which $95bn is exported. This makes it the largest of all the metals by a wide margin and the second largest global commodity market by value. The market for crude oil, the largest of all the global commodities markets, is estimated to be almost $1,000bn (Table 1).
Today, the seaborne trade dominates the global market, since the largest iron ore deposits are located far from the primary sources of demand. Roughly two-thirds of the seaborne market is controlled by the ‘big four’ producers: BHP, Vale, Fortescue and Rio Tinto. Half of all iron ore is mined in Australia (~$50bn/yr seaborne exports), Brazil (~$20bn) and China (~$18bn), although the first two countries are large net exporters and China is by far the world’s largest net importer, with a 62% market share.
To place this in perspective, the second and third largest global import shares are those of Japan and South Korea, at 8% and 5%, respectively. China therefore dominates the demand side of the market, with the supply side being more widely dispersed. This stands in sharp contrast to the global crude oil market, in which internationally traded supply is dominated by OPEC members and Russia, with demand being widely dispersed.
Note: April prices used
Iron ore demand is almost entirely a function of steel demand, which in turn reflects demand for infrastructure and general construction and manufacturing. Depending on the specific form of steel desired, iron ore fines are first ‘rolled’ into slabs, billets, or blooms. Slabs are rolled into sheet metal or plates. Billets are rolled into bars, rods, and wire. Blooms are rolled into structural steel, such as I-beams and rails. In modern steel mills these processes normally occur in one continuous assembly line, with ore coming in and finished steel products coming out. The exact mix of iron ore input reflects the desired mix of output, with lower grades more likely to be formed into structural steel (construction) products and higher grades into sheets or plates for use in a broad range of general manufacturing activities.
Taken together, crude oil and iron ore are today the most important globally traded commodities and are therefore both proxies for general global economic demand. As the Financial Times noted in 2009, ‘Iron ore may be more integral to the global economy than any other commodity, except perhaps oil.’
Unlike crude oil, however, iron ore has no large and growing range of substitutes. While there are many known alloys that are both lighter and stronger than steel, they are prohibitively expensive for use in most general construction and manufacturing activities. Non-metallic composite materials show some future potential, in particular for niche uses, but it is unrealistic to expect them to replace steel on any reasonable investment horizon.
The situation with crude oil is far different. Although ‘green’ energy development has a long way to go and depends on subsidies of one form or another in nearly all cases, the global Liquified Natural Gas (LNG) market has been growing rapidly in recent years. Battery technology also has an impact on demand, shifting fuel requirements away from crude distillates to base power generation (most commonly a combination of coal and nuclear). Crude supply, more closely controlled and possibly also used for political purposes occasionally, has idiosyncratic characteristics that can have large effects on price. These were demonstrated clearly by the dislocation in the crude oil futures markets in April this year when prices went outright negative for a brief time.
There are also some idiosyncratic factors of relevance in the iron ore market, although these have declined in recent years as the industry has geographically diversified and modernised. For example, iron ore supply and demand demonstrate some seasonality, reflecting changes in the weather and temperature. As a general rule, steel production is at its lowest in February and reaches a seasonal peak in May-July. Thereafter, it trails back down. The average net fluctuation in production from trough to peak is about 25%.
There are also tariffs levied on iron ore and steel, and, as with all such levies, these are subject to change. While the weighted-average tariff on iron ore is less than 3%, that for steel is normally higher due to the more political nature of the steel industry. Depending on the type of steel involved, weighted tariffs average in the range of 4-6%.[1]
Although iron ore still lags far behind crude oil in terms of the total amount traded by value, and may continue to do so indefinitely, due to the above oil supply and demand factors it is likely to demonstrate a more consistent correlation to general global economic activity in the future than crude. In this regard, iron ore is the ‘new crude’ in the global commodities space.
More evidence for this view is the correlation that iron ore demonstrates with copper, the industrial metal with the longest benchmark futures price history and highest exchange-traded volume. Alongside oil, copper has long been traded as a global macro proxy. However, in recent years, while the correlation between copper and crude oil has declined, that between copper and iron ore has been generally higher and more stable (Charts 2 and 3). In terms of how iron ore prices behave, we can see that their volatility is higher than copper prices but less than oil prices, especially over 2020 (Chart 4).
Finally, our annotated history of iron ore prices shows that the largest driver of iron ore prices appears to be swing in global growth dynamics, especially China. Occasionally, there are idiosyncratic events like tariffs or supply interruptions that affect markets, but they tend to be short-lived (Chart 5).
| Chart 2: Iron Ore Becoming More Correlated to ‘Global Growth’ Commodities | Chart 3: Oil’s Correlation to Copper Has Started to Decline |
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| Chart 4: Iron Ore Volatility is Between Copper and Oil |
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Chart 5: A History of Iron Ore Prices Since 2009 |
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Why Iron Ore Futures Pricing Has Improved
Price discovery was generally opaque until around 2009, when, following decades of large, long-term contracts being negotiated between major players behind closed doors, pressure from new sources of demand resulted in an industry shift towards more transparent, short-term pricing. So iron ore naturally followed along a path that had already been well established for numerous other commodities (see here).
As had been the case previously with Dated Brent and US natural gas, Platts entered the business of collating and reporting daily iron ore price information to the industry in 2008. At that point, they launched the IODEX index, which subsequently established itself as the primary iron ore benchmark reference price. This price represents the price of CFR inbound China seaborne cargoes for medium-grade iron ore with 62% Fe content, from two to eight weeks from delivery at port. This price sampling and index construction is meant to be the best representation of the Chinese seaborne iron ore market, which, given its large size, is a globally useful reference for iron ore prices in general.
With the introduction of the world’s first cleared iron ore swap on the SGX in 2009, the market made an important further step towards maturation and modernisation, comparable in key respects to the crude oil markets in the 1980s and the industrial metals markets in the 1990s. The benchmark 62% grade seaborne fines contract is now well established, with over 1 billion metric tonnes traded annually since 2015 and 2 billion tonnes in 2019 (Chart 6).
| Chart 6: Iron Ore 62% Volume and Open Interest |
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Along with the rise in contract volumes has been the entrance of non-commercials into the market. As of 2019, funds and PTGs drove roughly one quarter. Moreover, banks and brokerages drove 40% of contract volume (Chart 7). While some of that activity represents commercials on the other side, a portion almost certainly reflects degrees of risk warehousing or speculation as positions, whether physically covered or uncovered, are dynamically managed through intermediaries. This non-commercial activity attests to the growing depth and liquidity of the market.
| Chart 7: Breakdown of SGX Contract Trading Activity 2019 |
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This general increase in use of the contract, be it for hedging or speculation, has resulted in a significant increase in volumes not only in the first contract, but several months out the strip (Chart 8). This additional liquidity thus allows the potential to ‘roll-up’ or ‘roll-down’ the strip if desired, for example to arbitrage between the costs of physical storage, including portside, and the fluctuating prices for seaborne cargoes. It also enables traders to create synthetic, positive carry positions to potentially enhance returns.
Chart 8: Iron Ore 62% Volume by Contract in May 2020 |
| Source: SGX |
Due to the contract being settled based on the average monthly price, rather than that on the last day of the month only, liquidity in the front contract tends to trail off by the middle of the month as participants roll forward (Chart 9). The second month thus serves as the most active overall, with the third month contract volume increasing as the first month volume declines. Volumes trail off thereafter, with only little activity beyond six months, where swaps rather than futures dominate the paper market.
| Chart 9: Iron Ore 62% Volume by Contract Month Over Period Jan to May 2020 |
| Source: SGX |
In addition to settling at the monthly average price, cash settlement in iron ore futures should also be seen as an advantage over WTI crude as a macro proxy because there are less likely to be price distortions caused by specific location mismatches in supply, demand and storage capacity over the course of any given calendar month. Rather, the index calculations are from a wide range of FOB seaborne cargoes instead of a smaller sample of portside warehouses, for which a physically, end-of-month deliverable contract would be required for robust physical, rather than cash-settled, price discovery.
Understanding Iron Ore Grading
One clear similarity that iron ore shares with crude oil is that there are several different major traded grades. Some iron ore deposits are of high enough quality and concentration to go straight into a blast furnace designed to handle the generally higher content of ‘penalty elements’ therein contained. More commonly, iron ore is refined prior to smelting, reducing the concentration of impurities. Refined ores, known as ‘fines’, tend to contain between 60-70% iron. Fines of this concentration therefore provide the benchmark for iron ore pricing, with 62% fines being the most common specific reference point.
Ore grades that vary from 62% tend to trade at spreads driven primarily by their lower/higher metal content but also the presence of specific impurities, some of which can increase the costs of running an efficient blast furnace operation. These include primarily silica, aluminium, phosphorus and a few other trace elements.
Modern steelmaking facilities can deal with all of the above for known additional costs and maintenance, hence why the various ore grades tend to trade as near substitutes to one another. As a general rule, when margins are high (that is, when the market price of steel lies higher than normal above that of ore) demand for high-quality ore rises in order to run mills more efficiently (that is, without the additional ore preparation and maintenance that would be required to deal with impurities). The reverse is also true, so that when margins are low, lower ore grades will be preferred if they trade at a sufficient discount. In any case, historical data demonstrate that spreads for the vast bulk of ore grades tend to be only a few percent above/below grade 62% fines, when adjusted properly for metal weight.
Conclusion
Iron ore has long been the world’s largest globally traded metals market, and, in recent years, price transparency and discovery have evolved to the point where iron ore can serve as a useful, nearly real-time macro proxy on a level comparable to copper and, given the changing structure of supply and demand, probably better than crude oil. As was the case with crude oil and copper previously, liquidity should therefore follow suit in a ‘virtuous circle’ characteristic of successful evolution of listed futures and options markets.
Appendix
Historical Background
While iron ore has been an important commodity since ancient times, used primarily for making steel tools and weapons, it was only with the 19th-century invention of the Bessemer process utilising a forced-air blast furnace that a large, globally traded market in iron ore began to develop. In Europe, plentiful iron ore deposits were found in the Ardennes, northern Scandinavia and Russia. In North America, deposits were found in the Allegheny mountains and eventually further west and north around the Great Lakes and Canada. In Asia, Manchuria and the Korean peninsula were found to be rich in iron ore deposits.
Steel mills naturally sprang up in locations that had good access both to iron ore and coking coal, such as the UK Midlands, the German Ruhr valley, and Pennsylvania in the US. As steamships entered general use during the late 19th century, both iron ore and coking coal could be economically transported on a global scale, and steel mills were therefore also built in locations sometimes far from deposits. Indeed, for much of the 20th century, steelmaking capacity was perceived to be essential for national security. It is no coincidence that the modern European Union began as the European Coal and Steel Community, a successful effort by France, Germany, Italy and other members to pool their previously nationalised ‘warmaking’ resources.
John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.
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