Iron ore, the little commodity with no market

Today’s story is BHP’s breaking from the peloton of iron ore producers, to push for a market.

BHP Billiton has broken with its iron ore rivals Rio Tinto and Brazil’s CVRD, calling for the commodity to be traded in a more transparent market like that seen for thermal coal rather than in the “outdated” benchmark pricing system.

During an analyst tour of BHP’s Pilbara iron ore operations this week, the carbon steel materials marketing head, Peter Toth, indicated his company was unlikely to gain a so-called freight premium from its customers next year.

Mr Toth said his company’s new strategy was to move its expiring contracts onto an “iron ore index”, with forward deliveries and financial swaps that better reflected the spot market than the “outdated” annual benchmark pricing system.

But to make the switch it is likely that BHP – the smallest of the top three iron ore producers – will need to convince Rio and CVRD to join its push.

A Rio spokesman yesterday said his company supported the current benchmark system and felt it was flexible enough to accommodate various pricing issues being discussed.

One can see their argument (BHP’s): during a commodities boom, one would like appreciating spot prices. It means profit. This bench-marking system, though, works thus (more or less):

  1. Japanese or European steel makers strike a new price with ore suppliers in annual negotiations
  2. That becomes the bench-mark price

Australian producers have typically been upset by this because, given their proximity to Asia (source of said commodities boom), they can transport ore more cheaply – and would like a premium price for that. This is still the stated concern (Brazil, though, mines ore of a higher quality – so retaliation is not off the cards).

On the side of the purchaser, however, there is the risk of large re-sets. China, for example, was very vocal last year, after a 19% increase followed a 71.5% increase the year before. The bench-mark is inefficient (a) because it presents annual, potentially very large, increases, rather than randomly-walking spot price, and (b) because, like China, you’re basically hosed by prices that land on you like a tonne of, well, iron ore.

There is an excellent interview, actually, between Alan Koehler and Jose Carlos Martins (from big Brazilian firm CVRD), concerning the process.

ALAN KOHLER: One of the more curious rituals in commodity markets is the annual negotiation of iron ore prices. Each year BHP Billiton, Rio Tinto and the biggest iron ore producer, Brazil’s CVRD, sit down separately with the key steel makers across the world and hammer out new prices. And remarkably, they come up with the same price. Last year it was 71.5 per cent increase across the board. This year it’s 19 per cent. I spoke to the head of CVRD’s iron ore division, Jose Carlos Martins, after a speech to the Melbourne Mining Club this week. Jose Carlos Martins, we have three dominant producers in the world of iron ore. Is it like OPEC now?

JOSE CARLOS MARTINS, EXECUTIVE DIRECTOR OF FERROUS MINERALS, CVRD: Far from it. OPEC is something built by governments. We are market – have nothing to do with governments.

ALAN KOHLER: It seems to be a cartel?

JOSE CARLOS MARTINS: Far from it. There is a lot of competition in the market, a lot of players.

ALAN KOHLER: So how come it’s exactly the same price rise for all the producers each year?

JOSE CARLOS MARTINS: It’s because there is a system in place which is called the benchmark system. Normally one player fix a price with one customer and this price spreads all over the market. It’s a way a lot of other products’ prices is established. Even in the steel industry, the price is established rather in this way.

ALAN KOHLER: But if there’s competition between the iron ore producers, why is there no price competition? Why don’t you undercut BHP and Rio Tinto?

JOSE CARLOS MARTINS: You have costs to cover. Mining is a very complicated industry. When you increase production, for instance, price goes up. This is an industry where you don’t have economies of scale. Nowdays, for instance, to increase production to supply customers, we are operating with higher costs. It’s a completely different system than other industries.

ALAN KOHLER: Do you have meetings with your competitors?


ALAN KOHLER: So how is the benchmark price conveyed to them?

JOSE CARLOS MARTINS: I don’t know. I don’t know. You have to ask them. What I think – it’s the benchmark price conveyed to our customers. We set the price with our customers. Our customers accept the price. Our competitors – I don’t care. It’s their decision. What is important for us is our customer accept our price. The consequence of it is a marketing decision that our competitors have to take a decision for themselves.

He will forgive me if, after only having just taught Oligopolies to my students, I am not easily convinced. Markets with few sellers just don’t work that way. Of course you care what your competitors do – it affects your revenue directly.

With regards to China it/herself, M. Martins had this to offer:

ALAN KOHLER: Obviously this time around, unlike the Japanese and European and Korean steel makers, the Chinese don’t think that the 19 per cent increase is good for them. To what extent has that to do with the Chinese Government or the steel mills in China?

JOSE CARLOS MARTINS: I think China is in a process of learning. They are becoming a market-oriented economy and the learning process is a very difficult process. They have been accepting the system. We sell to China several years so they have been accepting the benchmark system all of this year. This year, they would like to be the price setters but the process is very dynamic. We have six, seven people all over the world negotiating with various customers. I never know with whom the price will be fixed and the system in China was a little bit not so fast. They had to caucus between them several times, the Chinese steel makers, each one have a different situation.

ALAN KOHLER: Do you think they’ll ever get to the point where they’ll be big enough to be the price setters in China?

JOSE CARLOS MARTINS: Yes, I think they deserve it by the size they have. I think they deserve. I think they will, but they need to be faster in their decision making process.

ALAN KOHLER: Will that be next year, do you think?

JOSE CARLOS MARTINS: Maybe. But one thing is for sure, they need to be more… Their perception has to be more related to the world market because iron ore is a global market, it’s not only China, it’s global. So they have to adapt their perception, not only to the Chinese market, but the whole market and they have to be faster in their decision making process. Will you be looking for another price rise next year? I don’t know. It’s too early to say. I don’t know. It’s too early to say. Too early to say.

Only slightly obnoxiously paternalistic, but an excellent example of the hill, up which BHP is now attempting to battle. Martins seems honestly (or at least consistently publicly) to believe his market is competitive, and that China just doesn’t get it (although they’ve had some success). At the end of the day, producers get their money. That 71.5% increase, for example, was only partly made up of costs for the coming year: part was also getting back profits lost through the previous year, as the previous benchmark was left behind by other inflationary factors.

One can see the appeal, for companies. One belt of negotiation, and then stable prices for a year. If you negotiated a bad price, you build some indemnity into next year’s price.

The same will happen this year, and then people will be laid off, ‘things’ (cars, houses, buildings) will cost a lot more, inflation in the US will still, magically, only be 2% or so (I don’t know how they do it!).

There is, naturally, the other hand. Specifically, BHP’s plan. Having access to a spot price is only part of it:

Mr Toth said his company’s new strategy was to move its expiring contracts onto an “iron ore index”, with forward deliveries and financial swaps that better reflected the spot market than the “outdated” annual benchmark pricing system.

With regard to a new iron ore pricing mechanism, Mr Toth noted the success of the globalCOAL energy coal index, which connects big coal producers, such as BHP, Rio and Xstrata, with buyers.

A globalCOAL spokesman said his company had so far traded more than 67 million tonnes of physical and financial thermal coal on short- and long-term contracts since the start of the year.

The globalCOAL spot price of coal from Newcastle is $US76.95 a tonne, well above this year’s contract price of about $US52 a tonne, thanks to the loading constraints at the port.

The spot iron price in China is higher than $US150 a tonne – about twice the price of Australian iron ore including shipping to China.

A UBS analyst, Glyn Lawcock, said: “Perhaps over time, depending on the price indices chosen, [it] would be a step in the right direction towards achieving the freight equalisation.”

BHP has already threatened to sell some of its expanded iron ore production on the spot market in the absence of a freight premium.

The iron ore market is said to be tighter than it was before a 71.5 per cent price rise in 2005, and some analysts are predicting a benchmark price rise of at least 50 per cent.

So BHP is interested in more than just the price it can get for its ore: it is interested also in the prices that can be affixed to the contracts it has, to supply ore. That is another dimension. One can also see where resistance comes in: Non-Asian factories (or countries) and Brazil will not be able to participate in this so easily (the distance thing). Moreover, as we’ve seen with oil, big buyers of iron ore don’t want their prices to appreciate (or become volatile) on the backs of dickhead speculators, their leveraging and their carry trades (they sold off their orchestras).

If BHP is selling the contracts, of course, it will benefit from that. So, too, will other Australian companies but, being bigger than BHP, they are also less likely to go off messing about with a model that has served them very well for a long time. Which gets back to Jose Carlos Martins’ interview: non-competitive markets (e.g. oligopolies), especially those that are thus thanks to control over natural resources, do not much go in for the introduction of competitive market mechanisms.

If you have a market, with only a few players, and you let them play in that market for long enough, they’ll work out something that serves their interest best. Odds are, that’s what they have right now, and they won’t want to give it up.


4 comments so far

  1. Rajiv Asthana on

    well written. Specially the last part. “they’ll work out something that serves their interest best. That’s exactly what’s happenning.

  2. […] curious about what this means for the future of the bench-mark pricing of iron ore. If you recall BHP, the smaller of the Big Three (relative to Rio and CVRD) wanted a […]

  3. Hans on

    No Comment

  4. LahCrandinfisa on

    Tahnks for posting

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