Market Dynamics Report

MAY 1 2015

Iron Ore: swapping the physical for the paper trade

The iron ore markets have seen significant developments recently as global producers adapt to the changing demands of a slowing Chinese economy. Price fluctuations and speculations are abundant, with news of global players increasing production, lowering costs per tonne and pricing smaller producers out of the market. Ramifications are widespread, with Australia's economic downturn and currency devaluation being largely blamed on a decrease in iron ore trading with China.

Finding the good news against this backdrop might seem like finding a needle in a haystack; however, traded volumes are on the rise, with iron ore the fastest growing commodity market in the world. And although prices of the physical asset are in decline, the trading of the physical and paper (financial) iron ore contracts continues to grow exponentially.

Iron ore is a relatively immature market when it comes to paper trading, when compared to coal for example. Swaps trading has only really taken hold in the last three years – and on screen in the last 12 months – as Chinese traders adapt their trading strategies and protect themselves against price fluctuations by hedging their positions. The increase in paper trading has been quite significant if we compare January 2012, when approximately 4 million iron ore tonnes were traded on SGX, to the approximately 79 million tonnes traded in January 2015. At the same time, the volumes of SGX cleared iron ore swaps has increased by 116%, with 581 million tonnes being cleared in 2014, versus 269 million tonnes in 2013.
From our perspective, another clear indicator of the market's potential to significantly grow over the coming years is the fact that the ratio of financial to physical trading is a mere 0.62 at the moment. This is very low compared to most other commodities markets which see financial contracts trade at a substantial multiple vs the physical underlying. In the case of crude oil the ratio rises to the hundreds. Although each commodity has its own characteristics and trading ratios vary across the board, it's clear to see that there's plenty of room for growth in the paper iron ore market.

We have seen that broker appetite for iron ore trading, both for the physical asset for delivery and crucially the financial trading product, has also significantly increased over the last 12 months. In part, this is due to iron ore being a high commissions, lucrative market. It is, however, also due to the fact that iron ore is a young market with plenty of growth potential. New participants will be attracted to this market as it offers growing volumes set against Chinese macro-economic developments and traders will increasingly be looking to manage risk through trading. Consequently, financial trading will likely continue to increase especially since it is a cleared market, easily accessible for financial counterparts and available on [the Trayport] screen.

While some analysts advise avoiding the commodities sector in 2015, and global economic shifts are influencing pricing of iron ore negatively, looking at the exponential growth in paper trading in this market tells a more nuanced and buoyant story.