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COLUMN-Atlas opens new chapter in iron ore pricing: Andy Home

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Andy Home

LONDON, July 15 (Reuters) - The spot price of iron ore touched a low of $44.10 per tonne last week.

That's the lowest price since 2008, which really means it's the lowest price since The Steel Index (TSI) started assessing the spot seaborne iron ore market.

Before then, iron ore pricing was determined by annual benchmarks negotiated between the world's biggest producers and consumers.

Much has changed in the intervening period.

The price boomed, reaching a peak of $191.90 early in 2011, and is currently going bust on a combination of slowing demand from China and too much supply.

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Pricing itself has evolved from producer benchmarks to hybrid quarterly pricing to fast-growing futures and options trading in the United States (CME), Singapore (the Singapore Exchange) and China itself (the Dalian Exchange).

Those trends have just converged in the form of Atlas Iron , Australia's fourth-largest iron ore miner, which like many other smaller operators is struggling.

Atlas' attempt to weather the current storm is predicated on hedging its downside exposure, a strategy that would have been impossible to execute even a couple of years ago.

HEDGE AND SURVIVE?

Trading in Atlas shares was suspended on April 2, shortly before the company disclosed it was closing all three of its mines and would need a fresh financing package to continue operating.

Since then it has slashed costs, entered into a profit-sharing agreement with its contractors and is trying to raise A$180 million ($134 million) via a share issue targeted at existing and new shareholders.

It has reopened its mines, the last of which is ramping up, and is targeting a break-even price of $50 per tonne, assuming a full run-rate of around 15 million tonnes per year by the end of the year.

That break-even all-in cash cost of production has already fallen significantly thanks to all the cost-cutting but with the spot price today at $49.40, it's still a perilously close call.

Which is why Atlas, quite possibly at the behest of its financial advisers, has initiated a hedging programme to limit its exposure to sub-$50 prices.

The programme comes in three parts.

Forward sales have locked in a price of $59 per tonne for 900,000 tonnes for the July-October period.

Put options have given Atlas a floor price of $53-54 for 400,000 tonnes over the July-August period.

And a cap-and-collar options programme covers another 1.1 million tonnes stretching through the end of the year, locking in a range of $50-60.

The timing of the announcement (July 8) and the price protection achieved suggests the company capitalised on the brief spike in the iron ore price back up to $65.40 in the last week of June.

The stated aim is to reduce exposure to further price falls over the next few months to allow its mines to hit the targeted 15-million-tonne annualised run-rate.

It's the sort of smart hedging seen in the base metals arena, particularly by producers looking for a pricing envelope during periods of capital investment.

CHANGING OPTIONS

Base metals producers have been able to use the long-established London Metal Exchange to achieve such hedging strategies.

Until a few years ago there was no similar option for iron ore producers.

But the iron ore exchange landscape has changed beyond recognition in that time.

The Singapore Exchange (SGX) was the first real mover in the iron ore trading space, initially in the form of clearing over-the-counter swaps.

However, those are rapidly being overtaken by the SGX futures contract. Volumes on the latter more than tripled to 225 million tonnes in the first half of 2015, while swaps volumes almost halved to 88 million tonnes.

Swap options volumes are still growing. They totalled 78 million tonnes in the first half of the year. But futures options are growing faster. Launched only in August 2014, they notched up 43 million tonnes in the first six months of this year.

Iron ore futures and option contracts on the CME are also growing exponentially, albeit not to the same volume extent as those on the SGX.

For a producer such as Atlas, in other words, there is an increasingly deep marketplace to find options hedging solutions to its short-term headaches.

It remains to be seen to what extent others follow in its tracks, although don't expect similar announcements from the big three - Rio Tinto (LSE: RIO.L - news) , BHP Billiton (NYSE: BBL - news) and Vale .

They have the lowest costs of all, which is why they still plan to bring on more capacity to force others out.

SURVIVAL OF THE FITTEST

Much will depend on whether Atlas' determination to fight on proves successful.

As the company noted, "while Atlas' sales strategies provide greater certainty of price over the current quarter (and some sales in the December quarter), pricing outcomes beyond this period cannot be guaranteed and are uncertain".

Well, quite.

Indeed, there is an irony here. If Atlas' hedging strategy allows it to ramp up to full production by the end of December, it will be part of the problem of oversupply and lower pricing.

The "dominate and saturate" stance of the big three means higher-cost production must be forced out of the supply chain if the market is to rebalance.

A lot of it has left, although pinpointing how much is difficult, particularly in the opaque small-scale mining sector in China.

But not enough to stop prices grinding steadily lower, barring that brief June correction.

Cost displacement, so attractive in theory, has turned out to be a messy affair in reality.

And Atlas will make it messier, if it escapes the abyss.

But this market is now all about survival of the fittest. If, like Atlas, you don't have the lowest costs, speed of opportunistic reaction is how you survive.

It wouldn't have been possible under the old producer-set pricing system. That it is now says a lot about how fast the iron ore market is growing up.

(Editing by Dale Hudson)