Miners apply the screws

Australia’s vice-like grip on global iron ore and coal prices is threatened by rising production costs and looming oversupply.

In the rarefied world of bulk commodities, where traders deal in quirky products like pork bellies, milk powder and gold, it can take years to change the way goods are bought and sold. Tradition is important in a market that has its roots in the early 1800s, and inno­vation doesn't happen overnight. Yet, ear­lier this year, the world's three largest producers of iron ore and coking coal suc­ceeded in their plot to dump a decades-old annual contract-pricing system in fa­vour of a quarterly spot market. The switch was achieved in a matter of months and there is already talk of daily spot trading on the horizon.

In theory, spot markets are good for buyers; it gives them scope to buy on the dips, or at least even out their purchases through the peaks and troughs. An annual off-take contract system, on the other hand, locks the buyer into a price that may have been set at the height of the cycle. So why then were the sellers -- BHP Billiton and Rio Tinto of Australia and Vale of Brazil -- behind the push for the spot market? The answer, in the words of one commodities analyst, is blunt and simple: "Now the miners can apply the screws to the steel mills every day instead of just once a year."

Together, the three companies control 75% of all seaborne trade in iron ore, and Australia is also the world's largest exporter of coking coal. With huge demand in China for these products, which are used to make steel, the trio has formed a cosy oligopoly, becoming price-makers instead of price-takers.

"Australia is abundant in the core commodities that China lacks," said Tom Price, a commodities analyst at UBS in Sydney, who added that the past decade has seen a shift in influence away from the Japanese and Korean mills. "China has distorted the nature of trade and, while some might say this presents risks for our economy, because of the difference in political philosophies, right now the brutal reality is that we have exactly what they need."

Steel mills will often do anything to get their hands on supply. The jailing of Rio Tinto executive Stern Hu in China in March this year, for allegedly taking bribes from steel mills in return for supply commitments, is an example of how the balance of power has shifted.

Oligarchy rules

One of the most vocal advocates of the switch to spot pricing was BHP Billiton's chief executive Marius Kloppers -- an intelligent and intense man who is often described as having a type-A personality. Kloppers was plainly peeved when buyers around the world reneged on their benchmark contracts during the height of the global financial crisis. In his view, this utterly undermined the downside protection that the contracts were meant to provide.

But Kloppers had other issues with the old system too. First, he thought that Australia should fetch a better price for its iron ore and coal than Brazil, thanks to Australia's proximity to China and BHP's ability to ship goods quicker. Then, he sensed that the annual price negotiations were being dominated by a few large state-owned mills, and that if the smaller steel mills could get a seat at the table, they might be prepared to pay more to secure supply.

With BHP, Rio and Vale pushing hard for change, the industry agreed to switch over to the new mechanism in April this year, though it is understood that the Japanese and Korean mills had to be dragged to the party. Quarterly iron ore prices are now set based on an average of the index price (published by Platts) for the previous quarter. Coking coal pricing works slightly differently, due to the lack of independent data sources, and is set based on negotiations between buyers and sellers (much like the old benchmark, only quarterly instead of annually). Some long-term contracts still remain, so it is estimated that about 60% of iron ore trade and 70% of coking coal trade is done using the quarterly system. Price at UBS said it's only a matter of time before the markets move to spot and "transform to something akin to gold", with all the customary derivatives securities such as forward contracts and options.

All of this is playing right into the hands of the big miners and their ability to influence prices. Analysts say this influence can be applied in many ways. The crudest method is to cancel deliveries, though this can be disruptive to long-term production schedules. A more effective method, and one that has little impact on existing operations, is to delay the construction of new projects. This puts pressure on the steel mills to accept prices that are higher than what they would otherwise have expected. Often, however, producers aren't always seeking to lift prices, rather to simply create support for existing prices when markets weaken. Unfortunately, no chart can effectively illustrate how and when this power is exercised. This is the current dilemma that China's steel mills face as they try to prove to regulators that the proposed joint venture between BHP and Rio in the Pilbara region consolidates the miners' pricing power.

China is doing what it can to challenge the oligopoly. One strategy has been to invest in second-tier miners. During the past three years, Chinese companies have bought equity stakes in Fortescue, Gindalbie, Murchison and Mount Gibson. These smaller companies produce a fraction of the tonnage of the big boys, but it is still possible for them to influence things at the margin. If BHP and Rio threaten to cut production by 10%, for example, these second-tier miners would certainly be capable of filling the gap.

"Often you can set prices with that last 10% of demand," said Chris Bain, chief investment officer of the Phillip Resources Fund. Bain said the consolidation of China's steel mills that is now underway will also improve the country's position. "Consolidation will help to stabilise the market because the smaller mills, which have been prepared to pay a bit more to get their ore, won't be around to push up prices."


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