BAOSTEEL, Ansteel and other big Chinese steel makers are likely to take a big hit to their bottom lines after Rio Tinto joined other iron ore suppliers in scrapping annual contracts in favor of short-term pacts aligned to surging spot prices.

On April 9, Anglo-Australian mining giant Rio announced it was moving to quarterly pricing of iron ore contracts, following similar actions by Australia's BHP Billiton and Brazil's Vale. Their decision effectively ends a 40-year history of setting benchmark prices through annual negotiations with major buyers.

China is the world's largest steel producer and importer of the iron ore used to make the metal.? The insatiable appetite that used to give China clout in driving down prices during annual negotiations has become a liability.

"Chinese steel mills have been using China's huge demand for iron ore as a weapon to seek more say in price negotiations," said Du Wei, a Umetal consultant. "However, that is also its Achilles' heel because the country relies so heavily on ore imports."

The shortening of contracts comes after iron ore spot prices shot up to above US$130 a ton this year, double the benchmark price of annual contracts signed last year. Amid rising prices, China's demand for steel shows no sign of abating as the government pumps more money into mega infrastructure projects.

China's steel output is forecast to grow 10 percent to 625 million tons in 2010, pushing demand for iron ore to 1 billion tons. Of that, imported ore is expected to surge 20 percent to about 758 million tons, Huatai Securities Co wrote in a report.

Steel makers who are already operating on thin margins will suffer, analysts said.

"Major steel producers, which rely more on term ore, will take a greater hit due to the surge in the cost," said Huang Jing, a Huatai Securities Co analyst.

The cost of steel making will rise 630 yuan (US$92) a ton, estimated Luo Wei from China International Capital Corp. The price of hot-rolled coils for March delivery by major steel mills was about 3,896 yuan a ton while cold-rolled products were around 5,357 yuan.

The profit margin of China's steel industry stood at a feeble 2.43 percent in 2009, far below the average 5.47 percent margin across the nation's industrial companies, according to the China Iron & Steel Association.

It's uncertain how much, if any, of the price increase steel producers will be able to pass on to consumers. Profit prospects for this year are looking less and less optimistic, said analysts, some of whom are already downgrading their forecasts for listed steel makers.

Citigroup has downgraded Angang Steel to "hold" from "buy" while rating Baosteel to "sell".

As of yesterday, Baosteel shares have fallen 20 percent so far this year, and Ansteel shares dropped 28 percent. Wuhan Iron & Steel fell 19 percent.

"The capability to pass on the costs hinges on the recovery of customers, including auto makers, home appliance manufactures and housing markets," said Luo.

Rio and other iron ore miners defend their actions as a matter of market realities.

"Rio Tinto's position reflects the recent structural shift in the iron ore market," said Sam Walsh, Rio's chief executive iron ore and Australia. "It is in line with our recent comments that benchmark pricing only works if it reflects market fundamentals, otherwise the system would need to change."

Rio's decision came after BHP Billiton said it had reached agreement with a significant number of customers in Asia to move onto shorter-term pricing arrangements. Macquarie Bank said BHP won a 99.7 percent price increase from customers in Asia for the current quarter. Even at that, the quarterly price would be at a 22 percent discount to current spot levels, Macquarie said.

Vale said it had closed iron-ore deals with 97 percent of its client base under its new quarterly contract system. Analysts said they are expecting Vale and Rio to extract price increases of about 100 percent.

Buying nations predictably unhappy with the situation have been forced to succumb to market forces. Japanese and South Korean steel mills have already signed shorter-term contracts. Chinese steel producers are still in discussions with the world's three biggest iron ore suppliers, still hoping to secure price discounts on longer-term contracts.

"We do not think the efforts will pay off," said Sun Fan, a Gold State Securities Co analyst. "Chinese steel producers will have to accept the hike in the prices and the quarterly-setting system eventually."

The current deadlock is reminiscent of 2009 negotiations, which collapsed after China sought deeper discounts after other Asian countries accepted a 33 percent reduction in benchmark ore prices. At that time, term ore prices were higher than spot prices amid sluggish demand that followed the global financial crisis, according to China International Capital Corp.

What a difference a year makes. Commodity prices have rebounded strongly amid signs of a global recovery.

"Iron ore prices are expected to continue growing as the world's major steel producers ramp up production capacities amid the global economic recovery," according to the consultancy Mysteel.

Rio chief executive Tom Albanese said recently he is optimistic about long-term growth prospects, given China's anticipated demand. He said China's demand for iron ore, copper, coal and aluminum is expected to grow exponentially for the next 15 years.

Still, caution prevails. China's tighter money policies, inflationary pressures and industrial overproduction could depress steel prices, analysts said.

"The problem facing Chinese steel mills is more long-term one than just whether to accept the iron ore price this year," said Umetal's Du.

He said China should form a strong alliance of steel makers to present a more united front against the strength of global miners.

At the same time, China has taken measures to clamp down on speculation. Earlier this month, the China Iron and Steel Association and the China Chamber of Metals, Minerals and Chemicals Importers and Exporters revoked the import licenses of buyers who handled less than 1 million tons of iron ore last year and ordered traders in China to stop buying low-grade ore for resale.

The grade of iron ore in China's deposits is less than half that of ore grades in Brazil and Australia, the world's two biggest producers. That means the unit cost of extraction in China is higher.

"Chinese companies should continue to seek investments in overseas iron ore resources to secure supply and offset the negative influence of volatile iron ore prices," said Du.