Energy & Resources, Talking Point

Steeling itself for defeat

Iron ore negotiating team may blink before the international miners

Steeling itself for defeat

A battle of iron wills

Hell, famously, has no fury like a woman scorned. But editors at Chinese state newspapers can work up quite a rage too, and they were pretty furious last month, on news that Rio Tinto, the Anglo-Australian iron ore giant, was doing some scorning of its own: of its suitor Chinalco’s $19.5 billion bid.

An act of perfidy, Xinhua fumed. Rio was behaving like “a dishonourable woman”. The damage to its reputation would be long lasting too: “There is an old Chinese saying: ‘A gentlemen’s agreement is beyond the letter.’ Honesty is the blood of business behaviour.”

Yet, while all of this was going on, stop-start meetings between Rio representatives and the Chinese steelmaking industry were ongoing too.

The discussions, on a contract price for iron ore, are part of annual arrangements in which miners and millers come to agreement on block volume delivery. Traditionally, the context has been a relatively gentlemanly one, especially in an environment in which transparency can be limited.

But this year the talks have failed. Or at least (as of this week) the Chinese had failed to agree terms for their own part of the deal. Adding to the confusion, Rio’s top negotiator in China – Stern Hu – has been arrested, along with his local colleagues, on allegations of unlawful access to commercial information (see China Ink, WiC24).

Hu could spend the rest of his life in a Chinese jail reports the newspaper, The Australian.

All of which suggests the stakes are rising…

What is the steelmakers’ negotiating position?

The background is China’s insatiable demand for steel – and for the iron ore that it needs to manufacture it.

Last year, it consumed over half of global ore supply (up from a little over 10% a decade ago) and two-thirds of the seaborne ore trade. The global ‘big three’ iron ore miners – Vale, Rio Tinto and BHP Billiton – dominate international ore distribution.

In recent years, steelmakers feel that they have been getting the worst of the deal. Contract rates for iron ore delivery in 2008 were up 96% over 2007, for instance, and ore prices have quadrupled over the last eight years.

The larger steelmakers have long purchased ore through a benchmark pricing system, in which a lead miner negotiates with a lead steelmaker to get to an annual price, which is then accepted by the remaining market participants.

Millers like the predictability of contract pricing, as pure market rates can be volatile. For example, spot prices more than doubled during the course of 2007, reaching close to $200 per tonne.

But as China’s share of ore consumption has grown, so has its desire for a fuller say in the annual negotiating process. Baosteel, the country’s largest steelmaker, took over from the Japanese as the lead Asian negotiator in the 2005 talks, and the Chinese grouping has been signalling over the last two negotiations that it expects to see prices come down.

And this year it was supposed to happen?

The Chinese thought so – and there has been a reduction of 33% on the most recent fixed contract price, signed by the Korean and Japanese steel mills. But the Chinese wanted to drive down prices by as much as 50%. March 31st was the final day for 2008 contract prices to apply, and China has been buying on the spot market ever since.

When negotiations began – and with much of the rest of the global economy in slowdown mode – Chinese steelmakers knew that their own consumption would be even more important to the miners. And they were counting on this to give them more elbow room during the bargaining.

And what agreement has been reached?

From a Chinese perspective, there is still no final outcome. CISA (the China Iron and Steel Association, which replaced Baosteel as the negotiating lead late last year) is saying that the discussion continues.

But as steelmakers in other countries have already succumbed to the miners’ offer, the Chinese look increasingly like they are out on a limb. Their own steelmakers have resorted to purchasing ore on the spot market – and the old method of setting a contract price through a commonly agreed benchmark looks like it is on the verge of collapse.

So what went wrong?

From a negotiating perspective, the window of opportunity to achieve the best terms was earlier in the year, when depressed global markets saw iron ore spot prices fall to $58 a tonne, a four year low.

But since then China’s own stimulus package – which has a clear infrastructure bias – has ramped up steel demand. So the Chinese were solving the miners supply problem – by demanding ever more ore – even while they wanted to negotiate their prices downwards.

In fact, Chinese steel output hit a new record last month. The programme of road, railway, port and housing construction continues apace and iron ore prices are forecast to soon hit $100 a tonne. Bloomberg reported this week that confidence seems to be improving in other markets too, and that other big steel players like ArcelorMittal and NipponSteel are charging up their blast furnaces again.

So there is now a sense that the window has closed for the CISA negotiating team – in the same way that different circumstances allowed Rio Tinto to slam the door on Chinalco’s proposed investment.

Perfidy comes in pairs, perhaps.

So the Chinese side will have to blink first?

It looks like it.

Further delays put the Chinese mills in a difficult position, especially if the spot market continues to rise. Cash prices this week hit $93 per tonne, which is already 20% higher than the contract price accepted by the Japanese and Koreans.

CISA was brought in as China’s lead negotiator last year, following criticism that Baosteel had not done enough to secure lower prices. But many of its members are now disgruntled by its approach, and admit privately that talk of further price reductions on top of those already on offer are unrealistic.

This is making it harder to maintain a unified front, despite the perception that Beijing usually acts as an effective ringmaster for favoured “pillar industries”.

With well over a thousand producers, the industry also lacks a dominant player. Baosteel – the biggest manufacturer – produced just 7% of domestic steel output in 2008 (compared to POSCO’s 62% in South Korea and NipponSteel’s 30% in Japan).

Now there are reports that other steelmakers are breaking ranks, and signing up to provisional contracts at the 33% reduction. The high profile arrests of the Rio Tinto negotiating team, as well as the investigations into their dealings with iron ore purchasing teams, may reflect this internal jostling for position within the industry.

This is particularly the case when some of the larger steelmakers have been using their ore import licences to profit from arbitrage opportunities.

Although it is not supposed to be allowed, some firms have been buying more ore than they need and then selling it on to local steelmakers (those without import licences) at spot rates. So they are doubly frustrated when they see climbing spot prices, but are unable to lock in supply at a lower forward rate.

So the miners have called Chinese bluff?

Analysts doubt the miners will compromise. Offering the Chinese more favourable terms would upset relationships with mills elsewhere in Asia. Plus they won’t be too upset about steelmakers continuing to purchase on a spot basis, as they’ll be expecting to get better prices as the year progresses.

All the same, the miners will want to allow for a face-saving outcome, and one option is to make the contract negotiations more frequent – the China Daily reports that China would like to see a quarterly round, for example. This would also allow CISA to claim that it has made some ground, even if the general impression is of a negotiation rather poorly handled – or at least rather poorly timed.

Most observers think that this is what BHP wants anyway. Recent research suggests that the ore producers lose more than they gain by offering fixed annual prices, although Vale, which has a higher cost of production and delivery to China, is keener on keeping things as they are. BHP is talking about continuing with contract commitments but setting them more frequently to an agreed set of indices. Rio seems to be keener on a fuller switch to spot market sales.

Some analysts reckon Rio may eventually get its way – especially as it becomes more difficult each year to reach agreement on a fixed annual price.

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