A slide in iron ore prices has driven miners to alter costly quarterly contracts to please Chinese clients, but spot pricing, which magnifies the impact of price swings, is still distant.

Iron ore's slump of 34 percent since early September revealed the flaws of a system that prices contracts based on the previous quarter's spot rates with a one-month lag, and opened the door for a more flexible mechanism for top consumer China while it grapples with weakening steel demand.

The pricing system is being adjusted to help consumers maintain margins in volatile markets, said Fairfax mining analyst John Meyer. It's about looking after your customers.

Up to 15 percent of iron ore sold by top iron ore miner Vale to China on a quarterly contract was at risk of default given the drop in spot prices, prompting it to shift its pricing method closer to the current spot rate, Macquarie Securities said.

At around $120 a tonne, spot iron ore is more than 30 percent cheaper than the fourth-quarter contract rate of around $175, which was the average of index-linked spot prices in June to August.

While Vale continues to sell ore to its European, Japanese and Korean customers on lagged quarterly contracts, it is selling to China at a provisional price with the final price based on the average spot price in the current quarter, Macquarie said in an October 24 report.

'NOT A FREE RIDE'

There is an ongoing shift to spot pricing but I think many companies will resist this and although there may be more spot pricing done this year, I would not call the end of quarterly pricing, said Meyer.

Instead, quarterly contracts may be adjusted toward spot market levels through the application of discounts and provisional pricing, he said.

Pricing the steelmaking raw material based on the daily market rate exposes both consumers and producers to volatility that can affect cashflow and operations.

If you're moving to spot pricing, then you're opening yourself up for a provisional pricing mechanism which can be very destructive, said James Wilson, analyst at RBS Morgans, who thinks a shift to monthly pricing will be more acceptable to buyers and miners.

With the ore price likely to change between the time the miner ships it and the customer gets it, spot pricing puts millions of dollars at stake as a single shipment of the bulk commodity can be easily around 150,000 tonnes, said Wilson.

Chinese steel mills are understandably opposed to frequent changes in pricing iron ore, the country's biggest imported commodity in terms of volume, with 2010 imports exceeding 618 million tonnes.

Steel mills prefer that iron ore prices are fixed on a longer-term basis as steel production is a continuous process, said an official in charge of buying iron ore for a mid-sized Chinese steelmaker.

If iron ore prices fall sharply, miners would usually offer some discounts to help steel mills cope with losses.

Rio Tinto, the world's No. 2 iron ore producer, 86 percent of whose third-quarter sales were on quarterly contract, said the market weakness was accelerating the move to pricing methods closer to spot.

The potential shift marks another phase in the evolution of iron ore pricing, which only moved to a quarterly system in 2010 after 40 years of setting rates annually.

That change followed a similar sharp fall in spot prices that forced a number of Chinese customers to renege on annual contracts in late 2008 following the global financial crisis.

But while Vale is willing to be more flexible with clients wanting to migrate toward pricing close to spot rates from quarterly contracts, the firm warned it would be a one-time switch.

It's not a free ride, it's something that both sides have to think about and look at what is better in the long term, Jose Carlos Martins, Vale executive director for marketing, sales and strategy, said on Thursday.

We're trying to avoid opportunistic situations.

TRANSITIONAL PHASE

It is clear, however, that the iron ore market will eventually move to spot pricing as growing risks push more players into the nascent derivatives market to hedge cost.

The current price slump lifted the volume of iron ore forward swaps cleared by the Singapore Exchange to a record 1,736 lots, or 868,000 tonnes, on Thursday. Open interest also hit an all-time high of 10,487 lots, or 5.2 million tonnes, the SGX website showed.

SGX clears the bulk of iron ore swaps traded globally.

Besides swaps, there is the less liquid futures market introduced in August by the Singapore Mercantile Exchange, following domestic-traded futures contracts in India.

We think the quarterly pricing system is a transitional phase on the way to exchange-traded pricing with a liquid futures market, said Gavin Montgomery, iron ore market analyst at Wood Mackenzie.

The GlobalOre trading platform being pushed by BHP will move the market toward this end, he said, referring to a new pricing platform for iron ore that BHP Billiton planned to launch at the end of this year or early in 2012.

GlobalOre aims to develop a standard contract for physical iron ore to be traded on its online platform by producers, consumers and traders, the firm says on its website.

The spot market represents round 20 percent of the estimated 1 billion tonnes of global seaborne iron ore traded annually, with the rest in long-term contracts.

But Fairfax's Meyer said the current pricing evolution could double the share of spot sales very quickly.

While Vale and Rio have mostly stuck to quarterly contracts, third-ranked BHP Billiton has been selling an overwhelming majority of its iron ore using a monthly pricing mechanism, Marcus Randolph, chief executive of BHP's ferrous and coal businesses, said this month.

At the end of the day, it all boils down to ensuring the miners' biggest market for their biggest money maker is satisfied.

If that means sacrificing a little bit in the way of pricing, then they do so to keep their Chinese buyers nice and happy, said Gavin Wendt, an analyst at MineLife in Sydney.