* Baosteel says Q3 will be most difficult time of 2010

By Yuko Inoue and Rujun Shen

SHANGHAI/TOKYO, June 8 (Reuters) - Months after sowing the seeds of a more flexible iron ore pricing system, Asia's steel giants are preparing to reap the whirlwind in the form of big cost rises, just as steel product prices show signs of flagging.

The world's No.2 and No.3 iron ore suppliers, Rio Tinto Ltd and BHP Billiton Ltd, have notified Japan's steelmakers that they want to raise iron ore prices by 22-23 percent in July-September from the previous quarter, a source said, sending shares of Japanese mills to lows for the year.

In China, by far the world's largest steel producer, market leader Baosteel has cut July prices, the first time this year.

But it will have to swallow a big rise in costs, since the quarterly prices are based on spot prices of the previous quarter when production soared.

"The third quarter will be the most difficult time of the year because that's when iron ore prices will peak if contracts are based on quarterly pricing as the three major iron ore suppliers have requested," Baosteel Chairman Xu Lejiang told reporters in Shanghai.

Brazil's Vale SA, the top iron ore producer, has already privately offered higher third quarter iron ore prices to its customers. One media report last month said it too was seeking a third quarter price hike of 23 percent. [ID:nTOE64I074]

China's steel sector held out for a favourable annual steel price at the same time as breaking more and more records for steel output, a stance that ironically made the annual pricing system vulnerable to change as spot prices soared.

"We haven't accepted the new pricing system but there's nothing we can do about it by ourselves. We're still trying to negotiate," Xu said.

Japanese steelmakers have yet to agree to the request from Rio and BHP, the source said. If they do, iron ore costs would rise to about $147 a tonne, more than double the price for the 2009 financial year.

That would be a further blow to Japanese mills, after they agreed with BHP to raise the coking coal price for the quarter by 75 percent from a year earlier.

Their shares are reeling amid worries about the global economy and the outlook for demand as well as weaker steel prices in Asia, their biggest export market.

"There's nothing but bad news," said Credit Suisse analyst Shinya Yamada. "Investors are fretting about a possible squeeze in margins at steelmills as product prices could sag while raw materials prices stay at a high level."

SHUTTING CHINESE FURNACES

Asia's steel market has sagged since hitting a high in the middle of April, with prices of billets in the Far East falling 20 percent in the past three months. 

On the other hand, JFE Steel said last month it was seeking to raise export prices for the July-September quarter by 10-20 percent, citing relatively solid demand for high-end flat steel used in cars and electronics and which is in short supply in Asia.

In China, signs of sagging demand in China include property transaction volumes that have dropped sharply in recent weeks as government measures to rein in prices started to bite. And car sales grew by the slowest pace this year in May, although still at a rather pacy 26 percent year-on-year rise.

"Demand from downstream industries such as auto, housing and home appliances will become relatively weak," Baosteel's Xu said.

China is also considering cutting back on export help for some steel products as part of a crackdown on wasteful and energy-intensive industries, media reports say.

The double-whammy of higher costs and slower demand may force China's mills to put the brakes on production, which was almost half the world's total in 2009 and hit a fresh record in April.

"I speak to steel companies. They're telling me that some of them are starting the maintenance of their blast furnaces early and will probably keep them shut," said Jing Ulrich, J.P.Morgan, chairman of China equities and commodities.

"So we will see, in the next couple of months, steel production probably coming off the peak because it's not very profitable now to make steel."

China's steel mills may have already reduced iron ore purchases. Data from China's Transport Ministry showed iron ore imports via major ports was 2.5 percent lower in May than a year earlier. Official Customs data is due to be issued on Thursday. (Additional reporting by Ruby Lian in Shanghai, Simon Rabinovitch in Beijing and Gowri Jayakumar in Bangalore; writing by Tom Miles)

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