IRON ore price-mating season is set for another tumultuous ride this year. And as John Garnaut warns today, the situation is likely to be as chaotic as last year with the possibility of not reaching a benchmark price settlement at all.
The benchmark system, put in place by the Japanese steel industry and the big iron ore suppliers in the 1980s, works by the leading supplier and buyer settling on the price annually and fixing it for 12 months, and the rest of the industry following.
The system first came under pressure at the end of 2007, when the big Australian suppliers started to move more tonnes into the spot market to take advantage of higher prices. A research note sent by Merrill Lynch to clients in September 2007 raised an important question: is it really fair that Indian iron ore suppliers were being paid twice what Australia's producers were getting paid just because the Indians were only selling spot? Should there not be an alternative mechanism?
In 2008, Brazilian supplier Vale was the first company to settle the price with Japan. But for the first time, the Australian suppliers did not follow the first price settlement and instead held out for a higher settlement. Rio Tinto subsequently achieved a higher price with China. Vale then tried to renegotiate yet another price just before the financial crisis hit. As spot prices dipped below the benchmark price, Chinese buyers tried to reduce purchases under benchmark price contracts, delaying shipments or buying on the spot market instead.
(The fact that Rio Tinto's willingness to pursue a higher price in 2008 had probably less to do with commercial conviction and more to do with shareholder and analyst pressure as a result of the BHP Billiton takeover bid, is an ancillary but nonetheless notable feature of this situation.)
A similar situation arose last year. On May 26 Rio Tinto settled a 33 per cent decrease with Japan and Korea for Pilbara Blend Fines. On June 10 Vale announced a 28.2 per cent price reduction with Japan and Korea but did not announce a settlement with China. BHP did not follow immediately but waited until July 29 to announce the same decrease as Rio Tinto's but for only 23 per cent of its iron ore volumes.
The rest had been settled on a negotiated basis or spot and index pricing, or still had to be settled. In another unprecedented move, Australia's new supplier, Fortescue Metals, made a separate price settlement with China for about 3 per cent below Rio's settlement.
Many industry veterans now believe we have to abandon the benchmark system. Since the Australians declined to follow the Vale settlement in 2008, the system is effectively broken anyway, and it is doubtful that Vale and the Japanese can put it back together.
The Chinese are an uncertain constituency in the debate - there are so many contending parties with vastly different interests. The China Iron & Steel Association proclaims religious adherence to the benchmark system but it is doubtful that the bureaucrats truly understand what it means. Some Chinese steel producers like the benchmark when the spot price is above the benchmark price but promptly renege when the spot price falls below benchmark. In other words, the benchmark is a negotiating tool.
Many Chinese producers have used the benchmark system as a means to bring their input costs down and to make a trading margin when they can get access to surplus tonnes. Many promptly reneged when the spot price dropped below benchmark in late 2008, further evidence that their supposed respect for the benchmark system is really a matter of expediency.
All this raises the question of whether a system that was put in place by the Japanese (at a time when the Australian suppliers were unable to effectively resist) can work in a period when the lead negotiator should be a China that seems to be incapable of achieving even a fraction of the level of consensus the Japanese achieved in its steel industry for decades. It is remarkable that seven years after China became the world's biggest importer of iron ore, it still struggles to assert control over pricing. This makes a reversion to pricing in Japan more likely the longer this year's stalemate drags on.
The other factor worth noting is that the Chinese are new in global commodity markets in general and are, experientially, coming from a domestic environment in which the prices of all key commodities have been controlled or influenced by government decree. Prices (markets) that are disobedient to government diktat or irreverent to the needs of the major state-owned enterprises are a new and discomfiting phenomenon. It will take time for institutions and business leaders to a) accept the new reality and b) learn how to be effective in such a context. As for achieving consensus, anyone who has lived and worked in China for long knows Chinese organisations are bitterly jealous of each other. Co-operation is only achievable by top-down fiat, and as China has moved towards a more market-driven economic, the independence of individual enterprises has become greater.
One of the key problems with a system that tries to squeeze 12 months of supply-and-demand dynamics into one single settlement is that it generates a pricing outcome that is out of date one day after settlement. If you slide into either excess demand or supply at some stage after settlement, one of the parties is necessarily at a disadvantage. Hence, the opponents of the benchmark system argue that win-lose constructs such as this one are inherently unstable and that the system has lasted longer than it really deserved to. Many of those who have been in the trenches negotiating the ''six-months-of-mating-dance-meets-Fight-Club'' format for years, cannot think of any process better designed to introduce tensions and discord into relationships between sellers and buyers.
A recent blog likened this seasonal event to the Wild West, complete with showdowns, threats, and hostages; well, we still do not know the facts surrounding the arrests of the Rio Tinto negotiators but you could be forgiven for seeing the arrests against this background of controversy and tension.
On the other hand, the proponents of the benchmark system argue that the system has achieved stability. One of the top Chinese steel producers remarked recently that it did not buy in the spot market and it did not expect the big suppliers to do so and that this had been clearly understood for decades. A Japanese steel maker said it was vital to know what your input costs were for 12 months.
Chinese and Japanese steel makers agree that daily fluctuations in the prices of iron ore make buying strategy and cost forecasting a nightmare. They also complain that a spot price system allows room for trading companies and speculators to provide more fuel for volatility.
The Financial Times said in a recent piece entitled ''The Iron Ore Pricing War'' that iron ore was now the largest commodity market after oil and argued that a failure of the benchmark system could lead to more price volatility, which would affect the profitability of both miners and steel producers.
One area where the big suppliers have some work to do is developing - or repairing - stable, long-term relationships. The quality of relationships and how they are managed is a critical and much-neglected element of how the mining industry conducts itself. It seems that many senior managers in the industry do not understand what a relationship is, in the East-Asian, Confucian context. In fact, it seems likely we will have moved back into a balanced market or a buyer's market again before the big mining companies will really put the energy into relationships that currently goes into most other technical and commercial aspects of their businesses.
The thing that may become a cause of real despair to both sides is how long this transition from one price system to another might take. We have a few more years of the annual brawl, in one form or another, in front of us yet.
Perhaps one key to the transition is buyers coming to terms with the possibility that a high-frequency transparent landed-cost pricing mechanism could be the best way of ensuring that investment in new iron ore capacity goes into the lowest-cost production worldwide. Until now, the dual-price system - which is effectively underpinned by allegiance to retaining the benchmark system - has misdirected new investment into higher-cost iron ore production, especially Chinese domestic production, thus perpetuating an average cost of iron ore well above where it would be in a proper market situation.
It would be nice to have great relationships among suppliers and end-users in the iron ore and steels industries, but change is hard, consensus is almost impossible and, when there are billions of dollars at stake, things tend to move glacially.
China is the big factor in this whole kerfuffle but, with its inexperience, xenophobia and ''Baby Huey'' sense of entitlement, the sequence of big losses of face that the market has inflicted upon it in the iron ore space has backed it into a tight corner.
Clinton Dines is a former chief executive of BHP Billiton China.
Philip Kirchlechner was Hamersley Iron's chief representative in Shanghai during the 1990s and Fortescue Metals' head of marketing until 2006. He is now a consultant to mining companies.
Source: The Age