Three major miners, Vale S.A. (VALE), BHP Billiton Ltd. (BHP) and Rio Tinto (RTP) control about two-thirds of global iron ore trading. The majors have used their market dominance to impose a new quarterly pricing mechanism which replaces the traditional benchmark system. The producers have reached agreements with most of the major mills in Asia, with the notable exception of China. Chinese acquiescence has been far from unanimous.
The China Iron & Steel Association (CISA) has responded to the new pricing regime by calling on Chinese steel producers to boycott the three largest iron ore producers. China Iron & Steel Association is a national, non-profit organization founded in 1999 that purports to represent the needs of China's steel and iron industry. According to the CISA, it now has over 119 group members whose steel output account for 92.6 percent of the total in the domestic steel industry.
The organization claims a national stockpile of approximately two months and seeks to leverage the threat of a short term boycott to either force iron ore producers to return to traditional benchmark pricing or at a minimum negotiate a rate below the current term price. While the CISA claims near unanimous representation, some members wish the organization would do less talking when it comes to global trade agreements.
The CISA developed a dodgy reputation among many Chinese steel producers after botching last year’s price agreement and demanding a 45 percent discount over 2008 prices. The subsequent failure of negotiations left China without an agreement for the year’s benchmark prices. Eventually major Chinese steel producers were forced to break rank with the CISA and individually sign contacts with foreign suppliers based on the Japanese benchmark price of about $63 per metric ton.
The remaining steel companies who rolled the dice without such an agreement were forced to turn to the spot market where additional risks and costs had a deleterious impact on the bottom line after spot prices rocketed well over $100 per metric ton in only a month after the negotiations failed. The 6 month average spot price was $96 per metric ton compared to the contracted price of $63 which represented a substantial premium in a difficult economic climate.
In 2010, the CISA has again strongly opposed the attempt by foreign miners to increase iron ore prices under the new shorter term contract. Their insistence on returning to annual contract pricing is falling on deaf ears. There is a general consensus that China’s bargaining position with iron ore suppliers has worsened, not improved.
Iron ore demand is increasing among Chinese steel makers and the CISA lead boycott is simply not credible. Ore producers recognize this and will not relent from their position, which grows stronger every day that global demand recovers and iron prices rise. If anything, we believe that China is even more dependent on foreign sources of iron ore. Quietly, a growing number of steel mills have accepted the new quarterly pricing system or negotiated private deals with their suppliers.
The collapse of the boycott is a fait accompli. However, what I personally find interesting and noteworthy are two small footnotes to this episode. First, China was not alone in bemoaning the skyrocketing price of iron ore and the imposition of a new pricing regime. European steel producers were more muted in voicing their displeasure but voice they did. What struck me was the more strident tone taken by Vale’s CEO Roger Agnelli when he publicly rebuked European critics by reminding them that the colonial period was over. Roger's retort provides further validation of what I perceive to be a growing assertiveness on the part of iron ore producers, particularly Vale.
The second minor footnote is a developing story that will play out over a number of years. In 2008-2009 Beijing aggressively tried to take advantage of the ailing global economy by investing in or purchasing assets or equity stakes from iron ore mining companies. This point was recently underscored when the iron ore negotiations became acrimonious and a Chinese official stated that China would eventually diversify its supply chain to the point where it would no longer be dependent upon the major producers.
Contrary to the assertions of the CISA, China is not going to be able to significantly reduce its dependence on the majors so long as it remains a major steel producing nation. But this epilogue does underscore China’s global strategy to diversify its iron ore suppliers to enable greater bargaining power, mainly by investing in smaller producers more susceptible to Chinese influence. Not long ago, West Africa signed an agreement with China Railway Materials Commercial Corporation to develop an iron ore project in Sierra Leone. China Railway will own around a 13 percent stake in African Minerals. China has also purchased stakes in two Australian iron-ore producers.
China continues to play out a long term strategic vision of global resources acquisition. This is a gradualist policy but one that will eventually bear fruit in a number of commodity related areas. This is a footnote with long term implications and well worth watching.
As an aside, I have returned to China to evaluate conditions and meet with friends and acquaintances I have come to know over the many years. Travel affords the natural synthesis between research, experience and first hand observation. I am currently in Shanghai and will provide further commentary on the emerging China and iron ore story.
Disclosure: Long Vale both in equities and options