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Imagine this. You make a product. You've got steep competition. As if by magic, you discover the exact price your biggest competitor is charging, and the precise terms of his contracts with customers you really want.

In other words, it's the perfect opportunity to say, "But wait! I can charge more!"

Welcome to the wacky world of iron ore.

This kind of remark might be heard behind closed-door meetings, as lawyers work out strategies for the next deal. But in most businesses, companies are all about competing on price and are quiet about how much they are making off their customers, at least until the annual report is released. Supply chain economics force businesses to compete for customers by being the lowest-cost provider ... usually.

Iron Ore Is Perverse

Iron ore is not a commodity with prices set in a continuous liquid market. Long-term benchmark contracts are negotiated each year between iron producers and steel manufacturers, and are not traded daily on the open market. Any unexpected demand or excess ore that is not covered in these long-term contracts is bought and sold in smaller negotiations - the spot markets - where price varies deal by deal and location by location. Here's how the latest Forbes described it:

"At the preliminary rounds of talks, each of the three biggest iron ore mining firms holds talks with the world's main steel-producing regions, each of which is represented by a single steelmaker, such as ArcelorMittal negotiating on behalf of the Europeans, Nippon speaking for Japan and Baosteel bargaining for the 16 biggest steel companies in China this year.

When one of the big mining companies strikes an agreement with a steelmaker after several months of closed-door talks, this benchmark will be immediately adopted by all three suppliers for the next year's contracts. In December 2006, Brazil's Vale first settled with Baosteel on a 9.5% iron ore price increase for the following year, setting the 2007 benchmark for the world's steel market." (Forbes 1/16/08, full article)

This system has been in place for over 40 years. The reason for this unique relationship has been to give stability to both miners and manufacturers as they create budgets for the coming year. It removes the necessity of hedging without the messiness of the futures market.

But things have changed a bit. Iron ore supply is tight. Demand is high, and projected to keep growing in the coming years, with China alone expecting an 11% increase in ore imports. (China in a commodities story? Shocking!) And, as reported in a Part 1 of an interview with Paul Quartararo, the steel industry is looking at an increase in steel consumption of 6.8% in 2008, even in the face of an economic slowdown in the United States. Because of this expected upward price pressure from both sides of the supply demand equation, miners like Rio Tinto are talking about increasing their participation in the spot market.

As we look forward to spring, long-term contract deals for April 2008-March 2009 have been announced and the industry is digesting what it means. First, on Feb. 18, it was announced that steelmakers in Japan and Korea agreed to a 65% price increase in iron ore from Brazilian company Vale. Vale has been busy this week, coming to the same 65% price increase agreement with Ilva, an Italian steelmaker, on Wednesday, and Baosteel on Thursday.

As the world's largest producer of iron ore, Vale has come out first with announcements in the negotiations, but the interesting thing to note is that the other two largest iron ore miners, BHP and Rio Tinto, have not jumped to follow the leader this time around. In fact, Rio Tinto has been vocal in calling for a freight premium, trying to take advantage of its mines' proximity to Asia compared with Vale's Brazilian ore. Unlike many commodities, iron ore contracts don't usually include shipping, so a miner gets no price benefit from being closer to their customers - the customer just pays less to the shipping company.

This attempt to extract some value from the "we're in Asia" card was tried and rejected three years ago, but between the threat of a BHP/Rio Tinto merger, the tight supply and current high spot prices in China, many analysts think Rio Tinto has a shot this time, despite some early balking from customers.

In other words, the ore suppliers have so much negotiating leverage that by breaking with tradition, they can essentially demand whatever they think is fair, and customers will have little choice but to pay up.

It's a nice business if you can get it.

Links

Rio Tinto May Break With Other Producers on Iron Ore Price New York Times, Feb. 21, 2008

China Needs Iron Forbes, Commentary, Nov. 21, 2007

Paul Quartararo Interview - Part 1 HAI, Feb. 19, 2008 (discusses steel industry-demand, rising prices)

Considering Iron HAI, Dec. 24, 2007 (Julian Murdoch)

Rio, BHP seek at least 71% theage.com.au, Feb. 20, 2008

Source: Iron Ore Breaking with Tradition?