China's largest steel maker Baosteel <600019.SS> and Rio Tinto have agreed on the highest price hike in at least over a decade in iron ore term contracts, the companies announced on Monday.

Baosteel has agreed to pay up to 96.5 percent more for its iron ore under a term contract with Australian miner Rio Tinto, higher than the 65-71 percent that Chinese mills and Brazilian miner Vale have clinched earlier this year.

But the company, which negotiated on behalf of the Chinese steel industry, said the traditional annual pricing system had been maintained despite an unprecedented divergence in the price rise of Australian ore and Brazilian ore.

To maintain the traditional pricing system and normal market order and to hold a long-term friendly cooperation between the upstream and downstream sectors, Baosteel has settled 2008 benchmark iron ore prices with Rio Tinto after friendly negotiation, Baosteel said in an emailed statement.

The company agreed to a 79.88 percent price rise for Pilbara blend fines and Yandicoogina fines, and a 96.5 percent price rise for Pilbara blend lump for the fiscal year 2008.

This is an extremely healthy price for Rio Tinto. It's about $14 higher than we had expected, said John Meyer, head of resources at Fairfax I.S. in London.

London-traded shares in Rio , which had been under pressure to get as high a rise as possible to justify its defence against a take-over bid from fellow Australian BHP Billiton, slipped slightly by 0.1 percent.

BHP Billiton has yet to reach an agreement with Asian mills. Its shares rose by 1.1 percent in London.

Stocks in Vale, the world's biggest iron ore miner, rose 2 percent. Analysts in Brazil say that even though the deal interrupts five years of other miners following Vale in setting benchmark prices, it showed that demand remained red-hot, which will likely benefit Vale when it negotiates 2009 prices.

And if freight costs diminish ... a return of joint price talks is possible, said Rogerio Zarpao, a Unibanco analyst.


BHP chief executive Marius Kloppers said the higher percentage rise showed the market had recognized the freight differential, or higher FOB price to offset lower shipping costs, that Australian miners had long sought.

He declined to say if BHP would agree to the same terms, but said it represented a small step in a needed adjustment for a disparity in freight rates from Brazil and Australia. [ID:nL23266931]

We're talking about a quarter of the (estimated) long term freight differential that was captured, but at today's rates it's only about a tenth, he said. Clearly this is something we need to work at.

Both BHP and Rio are now trying to move away from static term prices that for years have stayed well below spot rates for lower-quality ore, to an index system or some other, more flexible mechanism that reflects spot demand and prices.

They are also backing attempts to create iron ore swaps markets, and possibly someday an iron ore futures market [ID:nSP173780].

The price discovery mechanism is not efficient. You have such a big discrepancy between spot prices and contract prices for iron ore and steelmakers have to find an efficient way of pricing iron ore, said a commodities analyst in Europe.

This is going to be quite difficult.

But Baosteel, which has benefitted from relatively low term prices even as growing Chinese steel output caused spot ore markets to soar, was adamant the annual system still existed.

The result represents the sincerity from the two sides to maintain the traditional pricing system and a result from joint efforts of the enterprises that carry responsibilities, Baosteel said.

Chinese steel mills support Rio Tinto to boost investment and increase output further to meet market demand.

The new reference prices per dry metric tonne Fe unit for 2008 are US$1.4466 for iron ore fines, and US$2.0169 for iron ore lump, Baosteel said. (Additional reporting by Eric Onstad and Denise Luna; Writing by Lucy Hornby, Editing by Marguerita Choy)

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