What are iron ore futures and why are they important?
A commodity futures contract is an agreement to buy or sell a particular amount of commodity at a fixed price, on or before a certain date. Buyers use these contracts to avoid the risks associated with price fluctuations. And sellers use them to try and lock in prices for their commodities.
Futures contracts depict market sentiment and expectation regarding the future demand, supply, and price for a particular commodity. They reflect current market conditions in future prices. Investors should keep an eye on futures contracts’ prices and fluctuations to get an understanding of market expectation about future prices.
Backwardation in iron ore futures
The Dalian Commodity Exchange, or DCE, iron ore forward curve is in backwardation right now. “Backwardation” occurs when futures contracts trade below the spot price, and the futures curve begins to downward slope. This means that the market expects further decline in iron ore prices based on current indicators and fundamentals.
“Supply surplus” refers to low-cost supply additions that outpace demand. China, which consumes close to two-thirds of the seaborne iron ore in the world and is the largest consumer of iron ore, is currently experiencing supply surplus. So, China is the main contributor to the backwardation in iron ore.
The market condition opposite to backwardation is called “contango.”
The most active contract for January 2015 delivery is down 2.7% on DCE, after dipping 4.0% earlier. It’s now trading at 567 yuan, or about $93. Iron ore for immediate delivery to China also fell 1.1% to $82.2 per ton on October 16. This represents a slip from a three-and-a-half week high above $83, according to data compiled by the steel index.
Market sentiment turned negative because of weak steel demand and high production guidance from iron ore companies. We looked at this issue previously in this series.
Impact on companies
Backwardation in the iron ore futures curve indicates negative market sentiment about future prices. Decline in future prices is bad for companies including Rio Tinto (RIO), BHP Billiton Limited (BHP), Vale SA (VALE), and Cliffs Natural Resources Inc. (CLF), as well as for funds that invest in iron ore companies like the SPDR S&P Metals and Mining ETF (XME).