Overwhelming supply and slowing demand has seen the price of iron ore drop 30% in 2014. This is causing major concerns for miners, investors and importers with fears that a prolonged decline in prices could cause mine closures and even threaten the solvency of some producers. This Briefing will consider the current position and some of the legal implications of this development.

Supply and demand

Demand for iron ore in the Chinese steelmaking industry prompted miners, particularly in Australia, to invest billions of dollars in new iron ore mines, greatly increasing supply of the product. However, with economic growth and construction in China slowing, this new supply now exceeds demand.

Barclays Bank estimates that, assuming Chinese steel production grows at 5.1% per annum, there will be a surplus of 79 million tonnes of seaborne iron ore this year and 67 million tonnes next year. UBS estimates a surplus of 74 million tonnes this year, with a possible oversupply of 267 million tonnes by 2016. In spite of these forecasts, Rio Tinto is still aiming to increase its Australian iron ore output by a further 20% to 350 million tonnes over the next two years.

Impact on pricing

As might be expected, this has led to an overall fall in the price of iron ore but there have been other effects on pricing too.

There is a widening differential between the benchmark price of iron ore and that of lower grade iron ore. Iron ore with a high-grade haematite (i.e. iron) content of 62% is favoured by Chinese buyers. Using this grade of material in steel production is more environmentally friendly and allows for better utilisation rates. Spot prices for the import of iron ore into China are based on a 62% iron content. Iron ore of 58% grade is now trading at a $17 discount to the spot price. Other contributing factors are the oversupply of lower grade iron ore and reduced supplies of high-grade Chinese concentrate product, which is blended with lower grade iron ore to increase its iron content.

Seaborne iron ore is also now trading at a $20 discount to local Chinese product. This represents a tenfold increase in the price difference over the last three years. As a result, miners importing products into China have reduced the price of lower grade iron ore.

Ramifications for miners and investors

In addition to reducing the price of lower grade iron ore, large miners have reacted to the current market by seeking to save costs and thereby preserve profits. BHP Billiton recently cut 100 jobs at its Perth headquarters and a further 170 jobs at its Mount Whaleback mine.

Smaller and high cost operators may face even greater difficulties. The fall in prices may cause smaller Chinese producers to exit the market. Cairn Hill, an Australian producer of 50% grade iron ore, was recently put into administration. With prices predicted to continue falling and amid reports that 90% of capacity to hold iron ore in Chinese ports is already full, ultimately it seems likely that production from outside China will have to be reduced if the market is to be rebalanced.

That said, there are some who remain optimistic. Rio Tinto appears to be confident that its Australian mines will continue to generate profits and that high cost mines in China are those most at risk from the downturn. Although some investors have been selling off shares in mining companies, there are still some brokers recommending the purchase of shares in major mining companies. Furthermore, BHP Billiton and Rio Tinto are both still planning to increase their dividends.

Recommendations

The situation is reminiscent of the problems encountered by those importing coal into China in 2012. It remains to be seen whether a crisis will develop. In the meantime, it is crucial that those involved in the import of iron ore into China, whether as miners, investors or importers, are aware of the issues and prepared to meet the challenges that the market is facing.

All those involved in iron ore trading should make preparations but those with longer term contracts are most likely to be affected. They may find counterparties either refusing to perform or concocting reasons not to do so. There may also be an increase in disputes as to quality proceeding to litigation or arbitration which, in a better market, might have settled on commercial terms.

A number of steps can be taken to protect against default. For example,

  • Contract terms should be evidenced in writing.
  • Correspondence with a counterparty relating to a contract (including emails, instant messaging and other electronic communications) should be collected and stored to record what has been agreed. Parties should also consider recording telephone conversations during which contract terms are agreed.
  • Contracts should be “stress tested” to identify areas of weakness that a reluctant counterparty may try to exploit.
  • Strict compliance with contractual terms is essential to avoid a counterparty seizing an opportunity to terminate the contract.

If a default occurs:

  • Any additional time or other concessions granted to a counterparty should be carefully recorded in writing.
  • Any commercial settlement negotiations should be conducted on a “without prejudice” basis alongside open messages holding the counterparty in breach. This is to ensure that should the negotiations fail, the innocent party remains in a position to rely on its contractual rights.
  • Care should be taken not to act on a breach of contract too quickly, leaving an innocent party itself open to an allegation of breach on the grounds of premature termination. It is often prudent to write to a counterparty allowing an opportunity for it to cure any breach, failing which termination will occur.
  • Any contractual notice requirements, including as to form, address and timing must be strictly observed.