Vale , the world's largest iron ore producer, said on Thursday it is selling 80 percent of its ore using spot prices, nearly completing a historic shift to market-based pricing for the principal raw material used in steel.

The new system was prompted by Chinese steelmakers, Vale's largest client group, who wanted to benefit more quickly from falling iron ore prices. Iron ore averaged $141.80 a tonne in the fourth quarter, 11 percent less than a year earlier and 20 percent less than the previous quarter.

For decades, iron ore, the cornerstone of industrial civilization, was not tradable on a transparent market as copper, soybeans, corn and beef have been.

Annual benchmark prices were set in back rooms between a small group of steelmakers and an even smaller group of companies that dug the ore from the earth. Trading, where it existed, was limited and opaque.

A market in iron ore and iron ore futures and swaps now exists worldwide and is growing in size and transparency.

Vale's shift in pricing replaces contracts that were adjusted quarterly using past spot price averages. The quarterly

contracts were a transitional phase that replaced negotiated benchmark pricing in 2010.

Our expectation is for stability in the first half of the year with prices showing recovery in the second half, Jose Carlos Martins, the company's iron ore and strategy chief, told analysts on a conference call.

The remaining 20 percent of the contracts are largely with Japanese and Korean steel companies and they are expected to migrate to spot pricing, Vale executives said on the conference call.

While construction, a major source of demand for steel, has slowed because of Chinese efforts to cool their real estate market and because of seasonal construction slowdowns during the Chinese winter, Vale expects demand for steel and ore to pick up in the second half.

Demand will be driven by China's plan to build 10 million new units of affordable housing for middle and lower income families, Martins said.

Vale, which accounts for more than a quarter of the approximately 1 billion tonne seaborne iron ore trade, moved away in 2010 from a decades-old system of setting prices annually through negotiations between the largest steelmakers and the largest suppliers, including Vale, Australia's BHP Billiton and Rio Tinto .

Vale and its main rivals shifted to a system with contracts that set prices according to the average spot price of ore over the last few months. That system has now been largely replaced by prices linked directly to current spot market prices.

According to the Platts resources pricing service, iron ore is trading at $138.00 a tonne on Thursday.

The negotiated price system made it easier for the miners to plan investments in the giant mine, rail and port projects needed to supply European and Chinese steelmakers.

On Wednesday, Rio de Janeiro-based Vale said fourth-quarter net income dropped 21 percent to $4.67 billion, compared with $5.92 billion a year earlier.

The result was in line with the average estimate of 11 analysts surveyed by Reuters for a $4.68 billion profit.

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Mining giants' results: http://link.reuters.com/vys56s

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Iron ore production jumped 3.5 percent to 80.3 million metric tonnes in the quarter and reached a record 311.8 million tonnes for the year. Vale ships most of its output overseas, with around 40 percent bound for China.

The new pricing system has put pressure on Vale to increase efficiency. Rivals BHP and Rio Tinto, whose Australian mines are closer to China, have a transport cost advantage over Brazilian producers, Martins said.

VALEMAX

The main means for Vale to cut transport costs, the construction of a fleet of giant Valemax ships, ran into trouble in January after China refused permission for the 400,000 deadweight tonne vessels, some of the largest afloat, to dock in local ports.

Vale is working with Chinese authorities to end the ban but a solution will take time, Martins said. He said many Chinese ports can already handle the mega dry bulk carriers which are big enough to hold three soccer or U.S. football fields lined up end to end on their decks.

The Chinese ports were made, the majority, for 300,000 tonnes. The ports are relatively robust, with deepwater and many of them already have the conditions to receive the ships. It's a question of adjustment ... of licensing, Martins said.

Getting approval, though, is unlikely to be quick, he added and Vale has a backup plan.

Without Chinese access he expects the Valemax problem to be resolved in 2014 with completion of a 30-million-tonne-a-year iron ore distribution center in Malaysia. The center will work with a distribution center already operating at Subic Bay in the Philippines.

The centers will allow Vale to move ore from Brazil cheaply to Asia in Valemax ships and then transfer it to smaller vessels for the shorter voyage to Chinese ports, he said.

This is a game changer story for the iron ore market and we think it is good for Chinese steelmakers who can get cheaper iron ore, Martins told analysts. We are prepared for alternative solutions and as you know China needs ore and as time goes on all this will be solved.

Chinese shipowners, the main group opposed to the entry of the giant ships, have called for a halt to the Valemax fleet program.

Vale preferred shares, the company's most-traded class of stock, closed up 0.7 percent at 42.36 reais in Sao Paulo, while Brazil's benchmark Bovespa index ended Thursday up 1.2 percent.

(Reporting by Sabrina Lorenzi and Roberto Samora; Writing by Jeb Blount, Guillermo Parra-Bernal and Reese Ewing; Editing by Derek Caney, Lisa Von Ahn, Gunna Dickson and Phil Berlowitz)

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