Vale iron ore pricing brings profit damage forward

Monday, 12 December 2011

Vale's revenue from iron ore is expected to take a big hit in the fourth quarter after the Brazil-based miner agreed with most customers to switch to an iron ore pricing system that more immediately reflects a tumble in spot prices.
The price system switch will cost Vale about $1.5 billion in revenue from iron ore sales this quarter, compared with what the miner would have made by sticking to the previous pricing system, according to a Reuters calculation.
This decline in revenue would have been postponed to next quarter if the previous method had been preserved.

The switch was unavoidable for Vale, however, to prevent customers from migrating to other miners such as BHP Billiton and Rio Tinto , who offer contracts on even shorter pricing mechanisms, analysts said.
"Under Vale's former quarterly arrears pricing model, its profits in the first quarter 2012 would reflect this quarter's lower spot prices, so by renegotiating with some customers, mainly in Europe and China, in effect Vale has brought forward the damage to its profitability by three months," said Melinda Moore, principal of CleanUP Commodities Research.
"Vale's pricing methodology was unlikely to ever survive because of market volatility and because of an increasing majority of steel mill customers using more immediate pricing terms with their own downstream customers. Baosteel in China is one of the few mills pricing monthly; many others price spot or every 10 days," she added.

NEW PRICING FORMULA
Vale has agreed with nearly 80 percent of its customers to switch to a pricing method that is based on the average spot price for the quarter in which the ore is delivered, Vale's executive director of iron ore and strategy, Jose Carlos Martins, told a news conference on Wednesday.
The previous system was based on the average spot prices for the three months preceding the month before the quarter in which the delivery was due to take place.
The move was fuelled by a 31 percent plunge in spot iron ore prices in October, which prompted Asian steel producers to scour for adjustments in pricing the steel-making ingredient to more closely reflect spot rates.

Vale said looking at average spot prices so far this quarter, based on the new mechanism, contract prices should be about 20 percent lower than if they were based on the previous method.
"Iron ore is the main product for Vale, and if they are using the new mechanism, which makes prices 20 percent lower, that is a lot of money," said Patrick Cleary, CRU steelmaking raw materials consultant.
"But obviously a lot of people were unhappy with the system since spot prices started to fall. Basically this is an admission that the previous system wasn't fit to pourpose."
The pricing change also has wider implications for the market. Vale until recently had been the most cautious of the major iron ore miners when it came to price changes.
BHP Billiton, on the other hand, has never kept secret its desire to move as close as possible to spot prices.

Vale's move to the new, shorter formula in not the end of the evolution of iron ore contract pricing, which until only two years ago was based on a decades-old annual benchmark system.
Iron ore contract pricing is destined to move much closer to the spot price in the near future, analysts said.
"This is a step nearer to something that is manageable, but I think the system will continue to evolve," Cleary said. "At some stage buyers will be unhappy to use quarter averages. The next push could be for monthly contracts."
Source: Reuters