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Cross-month loading iron ore seen pricier as non-hedgers focus on premiums

Iron ore cargoes sold on a floating-price basis with loading dates straddling the end of one month and the start of another, commonly referred to as cross-month cargoes, tend to be more expensive than those loading within a single month, according to some market participants.

Such a view is more likely to be held by those that do not hedge their positions in the futures market, and therefore focus mainly on the premium to the basis month used as the quotation period, rather than a cargo’s total price on a fixed-price equivalent, showed a survey of market participants and an analysis by S&P Global Platts.
The analysis of spot seaborne deals further showed that after normalization to Platts standard specifications, cross-month cargoes were seldom priced higher than single-month cargoes.

Another key reason behind the view that cross-month cargoes were pricier is that comparisons were made with deals that took place further down the trading chain, which implied longer documentation days and a seller with a weaker credit profile.

Focus on premiums
Following the breakdown of the annual benchmark pricing system in iron ore in 2009, the pricing of spot transactions has gradually evolved to comprise a mix of fixed- and floating-price mechanisms.

The ratio of spot trades done on a floating basis has risen through the years, according to spot trades tracked by Platts.

Floating-price cargoes that load during the end of a prompt month M1 and the start of the forward month M2 can be offered based on either the monthly index average of M1 or M2, although the cargo will likely arrive in China in M2.

Due to a persistent backwardation in the futures market, cross-month cargoes sold floating based on M2 are tagged with higher premiums than single-month cargoes sold floating on either M1 or M2, to make up for the M1-M2 paper backwardation, market participants said.

Mainly from comparing the premiums between cross- and single-month loading cargoes, a few market participants have said the former are more expensive than the latter, as they do not hedge using financial derivatives and therefore do not fully consider the underlying futures values as part of the total price of floating-price cargoes.

This view also makes cross-month cargoes easy to resell when they are priced on M1, especially in a rising market.

To illustrate, a cross-month cargo priced either M1+$2/dmt or M2+$4/dmt, when the M1-M2 paper backwardation is $2/dmt, has the same value on a fixed-price basis.

Non-hedging buyers would prefer to buy it priced over M1, even at a slightly higher premium, say $2.50/dmt, especially if they expect prices to rise, because they can secure a relatively low premium and an earlier QP.

Therefore, traders are incentivized to buy the cross-month cargo at M2+$4/dmt and resell the cargo at M1+$2.50/dmt, as they can lock in the M1-M2 paper backwardation of $2/dmt via hedging. They will realize a profit of 50 cents/dmt minus hedging and other operational costs.

Normalization effects
Platts compared all spot seaborne transactions observed from Jan. 1, 2020, to Aug. 31, 2021, and found that after normalization to Platts IODEX specifications, cross-month cargoes were not more expensive than single-month cargoes in most cases.

The normalization involved converting a floating price to an outright basis by adding the premium and underlying futures price around the trade timestamp, followed by adjusting for quality and arrival timing.

Trades based on price indexes without a liquid forward curve were excluded, as were those without clear timestamps or done after the Platts Market on Close assessment process and therefore did not allow accurate futures prices to be used.

Furthermore, cargoes with arrival dates falling outside Platts assessment window of two-eight weeks’ forward or without defined laycans were excluded.

Of the 31 days when trades of both cross- and single-month cargoes took place conforming to the above criteria after normalization, 15 and 12 days had a cross-month cargo priced lower than or equal to a single-month cargo loading in M1 and M2, respectively.

Only three days did a cross-month cargo normalize higher than an M1-loading cargo and one day had a cross-month cargo normalized higher than an M2-loading cargo.

Inventory accounting practices
Some steelmakers manage iron ore inventories based on QPs. If for some reason they have run out of M2-priced volume quota first, they may only be able to buy using M1 quota.

For instance, such a situation may arise if they skip taking term contract allocation in M1 and therefore have ample M1-priced quota.

These mills would therefore buy a cross-month cargo if the market no longer has M1-loading cargoes available. A trader who has bought a cross-month cargo priced on M2 from a miner can therefore sell it to such a mill priced on M1 and potentially charge a higher premium if the mill’s demand is relatively inelastic.

Given that miners tend to sell cross-month cargoes based on M2 — possibly driven by the higher premiums — traders are well-placed to facilitate such a trade between a miner and a mill.

Comparisons not apple-to-apple
Finally, a few market participants said cross-month cargoes are pricier because they have compared cargoes traded earlier in the trading chain — sold by a miner — to those done further down the chain.

While Platts does not treat trades differently in its assessment process solely by virtue of their positions in the training chain, market participants may value them differently due to longer documentation days for cargoes further on in the chain.

In addition, some may view specific traders less creditworthy than miners, and so transactions involving these traders as sellers could conclude at lower prices.

Such observed price differences are not caused by whether a cargo’s laycan is cross-month or single-month.

As such, the reasons offered by market participants for preferring cross-month cargoes highlight the need for greater awareness among buyers and sellers of how physical and financial markets for iron ore may interact in price formation.
Source: Platts

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