China's first tentative steps away from the 40-year-old iron ore benchmark opens a vexing question for its mills: how to convince new customers to adopt free market steel prices when it needs more long-term contract clients.

Touting its presence as the world's biggest buyer, China has sought a deeper iron ore price cut than the 33 percent reduction its Asian rivals had won, betting they can switch to the spot market if their demands were not accepted. They have also signalled a readiness to price sales on a quarterly or twice-yearly basis.

While such a change would allow them to benefit from any backslide in prices rather than paying higher rates for a full year, it also opens up more uncertainty for its costs -- ironically, just when Chinese mills are trying to secure more long-term contracts, typically priced annually.

Passing their cost instability onto clients would be a tough sell against more profitable global rivals such as Nippon Steel that have thus far stuck with the benchmark.

"If Chinese mills move to purchasing (iron ore) based on spot prices, it would bring a risk that material prices could become unstable ... Then the system of annual steel product price negotiations would need to be changed, which would not be well received by clients," said UBS analyst Atsushi Yamaguchi.

As commodity prices rose for most of this decade, China's mills enjoyed an advantage over their more traditional rivals by selling more of their steel products on a spot market basis, while paying for their iron ore at an annual price, which had typically lagged behind rising free markets.

Unlike Japanese and South Korean mills, Chinese steel makers do not have high levels of contract sales and depend more on the volatile spot market to sell their steel products.

IMPORT TURN

But with insufficient and expensive domestic reserves to feed an industry that produces nearly 40 percent of the world's steel, even their bread-and-butter products have become less competitive this year, forcing it to become a net steel importer.

China saw low-cost producers in Russia and eastern Europe flooding its market this year, while exports of its pricey products tumbled 60 percent.

"Chinese mills are already less cost-competitive than their counterparts in Japan and South Korea and that explains part of the reason why their steel export prices are higher than regional prices," said Kim Hyun-tae, a Hyundai Securities analyst.

Against this backdrop, sourcing iron ore in the spot market, which is now trading just above this year's benchmark prices and does not guarantee stable long-term supply, would create a conundrum to China seeking to boost exports to get rid of soaring output sharply in excess of its demand growth.

Despite its warnings that steel output should drop 8 percent this year, China's daily production hit 2009 high of 1.522 million tonnes between June 11 and 20, equivalent to an annual output of a record 555.5 million tonnes, more than 10 percent above 2008 level.

Various measures including tax benefits have failed to boost exports, as Chinese export prices continue to remain higher than regional prices.

Asian spot prices of hot-rolled coil are selling around $465 a tonne, while Chinese exports are priced higher around $479, even after the government's recent decision to raise export tax rebates by 9 percent, according to HSBC.

For graphics on China's steel exports, click: http://graphics.thomsonreuters.com/069/CN_STLEX220609.jpg

WORST TIMING

The timing of the swift to spot ore market can't come at a worse time, as global steel mills, many of which have been operating below 50 percent early this year, are gearing up to lift output, further eroding demand for pricey Chinese steel.

Japan's Nippon Steel, for example, plans to boost capacity run rates to around 70 percent in the current quarter from 55-60 percent in the previous quarter.

In theory, Chinese mills, which are already buying a significant portion of their ore requirements on the spot market, can hedge price risks by using iron ore derivatives.

But the absence of a deep liquid forward/derivatives market yet means deploying hedging tools will be progressive, rather than immediate.

That partly explains why some of China's larger mills have reportedly reached agreements with miners and issued letter of credit to buy iron ore at the price accepted by Japanese mills, weakening lead negotiator China Iron and Steel Association's position and ignoring threats to revoke import licenses.

Unlike Japan and South Korea, a staunch backer of the annual pricing setting mechanism, China has steadily moved to spot market. Its shift took a dramatic momentum last year, as many of its mills reneged on pricey long-term contracts signed prior to the collapse of the global steel industry in the fourth quarter and switched to cheaper spot market.

Spot iron ore prices to China have jumped 30 percent in three months to four-month highs, trading at around $65 a tonne free on board, slightly above benchmark price of $61 that Japanese, Korean and Taiwanese mills are paying to Rio Tinto this year.

Longer-term iron ore pricing outlook is more bullish, as global steel output is slowly recovering on the back of government stimulus plans across the world and reviving demand from the auto, construction and electronics sector.