Iron ore price revolution

05 Apr 2010 • by Natalie Aster

Marius Kloppers wasn't out there boasting. That would not have been politic in dealing with already agitated Chinese authorities and clients or European regulators considering BHP Billiton's proposed $US116 billion ($126bn) iron ore joint venture with Rio Tinto.

It would also have looked arrogant given the comparison with Rio's image problems, not to mention the fate of its abruptly terminated employees as they headed off to Chinese prisons.

But the bland statement from BHP last week was still as momentous as it was brief – and a huge victory for Mr Kloppers.

BHP simply noted that it had reached agreement with a "significant number of customers throughout Asia" – the majority by volume – to move iron ore contracts from annual price negotiations to a shorter-term basis.

It said this structural change was "consistent with BHP Billiton achieving market clearing prices".

Beneath the careful language is a revolution that is likely to have an enormous and long-term impact on the national economy, the future profits of iron ore producers, and quite possibly the diplomatic relationship between China and Australia.

In simple terms, BHP's announcement signals the breakdown of more than four decades of the benchmark system, a method of setting prices for one year that usually involved annual acrimonious, protracted and secretive negotiations between producer and customer.

Instead, iron ore prices will initially change each quarter according to the average market price of the previous three months, with ever greater amounts being priced at the current, or spot, level.

With the level of demand from China widely expected to continue increasing rapidly, that will inevitably mean much higher prices more quickly for Australian producers.

According to analysts contacted by The Weekend Australian, BHP is already securing increases of up to 100 per cent over last year for its new short-term contracts.

This compares with the jump of about 40 per cent that the Chinese steel mills were suggesting as an interim benchmark price. The world's biggest iron ore producer, Vale, has also managed increases of about 90 per cent so far with its Japanese customers for April to June.

The sharemarket is still digesting the significance of this, with the prices of the big miners initially falling on news of the announcement before rising again on Thursday. But if nothing unexpected happens to derail the momentum, the new dynamics of the iron ore industry would be worth several billion dollars to the bottom lines of both Rio and BHP in the coming year alone.

That, clearly, would also affect the money flooding into the Australian economy and the federal budget from the resources sector.

The Australian Bureau of Agricultural and Resource Economics already predicts export earnings from iron ore will reach $35bn next financial year, up from $29bn forecast this year.

This looks increasingly likely to prove an underestimation.

"The significance of what has occurred here has not yet really been understood," one industry observer said. "We will all look back on this in years to come and realise it was when the floodgates really opened."

Not only that, the BHP short-term contracts are for the first time now being done on a landed-price basis. That means Australia will benefit from its cheaper freight costs thanks to its closer distance to market relative to its major competitor, Brazil's Vale. The benchmark price system ignored Australia's comparative freight advantage.

Vale has agreed to a price of $US105 a tonne with Japan's Nippon Steel and South Korea's Posco, compared with the current benchmark, which expired on Wednesday, of about $US62 a tonne.

According to Lloyd's List, adding freight costs would take the "landed" cost of iron ore from Brazil to China to $US129.19 a tonne. "The landed cost from Australia would be cheaper at $US115.13, representing a substantial advantage for Rio Tinto and BHP Billiton," the specialist shipping news agency wrote this week.

The optimistic view is that this change might even reduce the chances of another case like that of the now imprisoned Stern Hu and his fellow executives responsible for negotiating Rio's iron ore contracts with China.

As there will no longer be the same potential for a huge gap between the annual benchmark price and the current market, or spot price, the potential for bribery, manipulation and side deals should diminish on all sides.

At the moment, for example, the current spot price is about double the benchmark price that expired this week – obviously making it much more attractive to suppliers to sell as much as possible on spot.

From now on, in theory, the market will become a more transparent and responsive arbiter of prices and Chinese buyers would therefore be less inclined to be resentful of individual companies' behaviour, and by extension the Australian government.

This view is not shared by Chinese authorities and buyers, which are extremely unhappy with the shift away from benchmark pricing.

This arrangement was established in the 1960s to deal with Japanese steel mills looking for reliable supplies of resources, and Australian producers looking for reliable customers and prices in return for major investments.

As the balance of economic power shifted, the benchmark negotiations were led by Chinese buyers, with the prices flowing through to the rest of the market.

Japanese and European buyers will be equally displeased with the changes. European steel mills complained last week that "there were strong indications of illicit co-ordination of price increases and pricing models and pressure on individual steel producers to accept these changes".

China, however, remains the dominant customer – and the more likely to try to retaliate.

Whether and how this will happen is uncertain, but given the inflationary and political pressure on China from rising prices, it is not going to make the Sino-Australian relationship smoother, at least in the short term.

In a hardly coincidental move, 10 Chinese steel mills have petitioned Premier Wen Jiabao to prioritise the iron ore benchmark talks as a "matter of national importance".

The significance of the BHP statement is that Chinese buyers have lost the main battle against change strongly pushed by Mr Kloppers for more than eight years. His determination started from the time he was marketing manager of a much smaller Billiton, rather than chief executive of the combined company, the world's largest miner.

Mr Kloppers told analysts in February, when releasing the miner's interim results, that BHP's commitment to market-based prices was longstanding.

"We have indicated that we are prepared to sell a product on the market clearing prices, whether that market clearing price is below the contract price or above," he said. "And over the last couple of years we have indicated that we are not going to sign any new benchmark contracts."

With that commitment came a recognition that market prices would, at times, move against BHP. Last year, for example, spot prices fell below the benchmark for a time.

The move to short-term contracts started with manganese and moved to coking coal exports – both, along with iron ore, key ingredients in steelmaking.

BHP moved the majority of its manganese contracts to a quarterly system in 2008 and last month revealed it had secured a quarterly deal for its coking coal contracts with Japan.

Until the past 12 months or so, the shift on iron ore was expected to be gradual, in the convoluted selling process, rather than an immediate radical shift.

This was partly because Rio, the largest Australian iron ore producer, supported the traditional benchmark system and wasn't promoting dramatic or rapid change.

In contrast, BHP insiders said their chief executive had been "relentless" about his ambition to move away from the annual benchmark pricing system and introduce market clearing prices for iron ore.

"At various times it has not always seemed the right way to go, because it could upset customers and rock the boat, but he persistently kept on and was always moving the company in that direction because he knew it could happen," a BHP insider said.

In the end, it came more quickly than even he could have predicted. UBS analyst Tom Price said Mr Kloppers had successfully pushed for change in the pricing of iron ore and metallurgical (or coking) coal, all within weeks of each other. "His lobbying for change to product pricing in the bulks trade, over many years, has led to this change in a long-standing trade custom," Mr Price said.

The convulsions in China's demand for resources over the past two years forced the pace of change and made the previous system too unstable.

Last year, for example, there was no benchmark agreement between Chinese buyers and Australian producers. Instead, prices with Japan and Korea were the default position.

That was because of the unbridgeable gap with the Chinese Iron & Steel Association, which led the negotiations on behalf of Chinese steel mills, insisting on much greater price cuts after the record increases of the previous year. The standoff was exacerbated by an increasingly poisonous atmosphere between Rio and Chinese authorities, not limited to the collapse of the $US19.5bn deal with Chinalco.

This also contributed to the antagonistic environment that resulted in Hu and other Rio executives being targeted last year.

At the height of the boom, and under pressure to bolster its profits to ward off BHP's attempted takeover, for example, Rio held back about 10 per cent of its contracted supplies, redirecting them to the more profitable spot market.

With the downturn, the Chinese buyers briefly responded in kind to all iron ore producers, refusing to accept some of their contracts based on 2008 annual prices and agreed volume.

By late last year, with the spot prices rising rapidly, the Chinese authorities' earlier refusal to compromise on price meant they lost out badly. Meanwhile, as old contracts expired, BHP was only renewing them on volume, as opposed to price, as it slowly moved customers to index, spot or quarterly pricing.

By July last year, BHP had moved about 30 per cent of its steel mill customers to short-term contracts, boosting that to about 46 per cent by the end of the year.

Last week, it hinted a majority of its customers had moved to the new pricing.

Despite the backlash from China, it is obvious some of the miner's Chinese customers have agreed to its version of the future.

The Melbourne-based miner sells 70 per cent of its ore to China, so many of its Chinese customers have clearly accepted the push away from the benchmark.

By February, the other big two producers, Vale and Rio, were also publicly reversing their position.

Vale iron ore boss Jose Carlos Martins alarmed China and Japan when he declared customers insisting on benchmark prices would have to accept something closer to spot prices. Last month, it quit annual price talks with China buyers that baulked at the 90 per cent price rise.

Rio iron ore head Sam Walsh also announced that the benchmark system was not evolving fast enough and changes in pricing were needed.

But Rio will continue to have BHP take the lead in pushing for this, given the delicacy of its relations with China.

Source: The Australian


More reports available on the product:

  • Iron Ore in the CIS
  • Iron Ore Market Review
  • China Iron Ore Market Research Report
  • Trends and Prospects in International Trade in Iron Ores and Concentrates, Roasted Iron Pyrites
  • Lead Market Review
  • Lead (CAS 35788-48-8) Market Research Report 2010
  • Trends and Prospects in International Trade in Lead and Articles Thereof
  • Red Lead (CAS 1314-41-6) Market Research Report 2010
  • Trends and Prospects in International Trade in Manganese and Articles Thereof
  • MANGANESE (CAS 7439-96-5) Market Research Report 2010
  • The Russian ferrous metal industry in 2009: state and prospects