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.