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Battle Looms In Iron Ore Negotiations
FN Arena News – September 28 2007
By Greg Peel
In 1998, China imported 52 million tonnes per annum of the world’s iron ore. In 2004 it imported 208mtpa and Merrill Lynch analysts expect the figure to be 400mtpa by the end of 2007. In 2001 China consumed 20% of the world’s traded iron ore. In 2007 it will consume 45% and account for over 75% of global production growth.
Chinese steel production continues to boom. At the end of last month, Macquarie reported panic among China’s smaller producers as iron ore prices rose steeply. Stock building at mills had pushed the spot price of iron ore from India up from US$75/t at the beginning of the year to US$140/t at the end of August. Australia does not sell iron ore to China on a spot basis, but rather on an annual contract basis. An annual contract runs for the Japanese financial period of April to March. Negotiations for JFY08 will begin in November.
Over the past several months Australian resource analysts have been slowly pushing up their expectations for a contracted price rise. This had served to significantly push ahead the share prices of BHP Billiton (BHP) and Rio Tinto (RIO). We had a credit crunch correction in between, but now we’re back again. The analysts at Merrill Lynch are currently factoring in a 30% price rise for Australian iron ore, but believe a 50% rise is quite possible. But Merrills also suggests that but for a longstanding arrangement, the price rise could justifiably be 100%.
Chinese steel mills are now paying US$171/t on the spot market for India’s low-grade iron ore. They pay US$136/t for domestic Chinese ore which is also of a low grade. The highest grade ore comes from Brazil’s CVRD and is a necessary ingredient in making steel of sufficient quality. For that the Chinese are paying US$118/t on annual contract. Australia’s iron ore is of superior quality but not quite to the level of Brazil’s. For Australian ore the Chinese pay only US$78/t.
Which begs the obvious question: If China is so desperate for iron ore that it would pay US$171/t at spot for low quality ore, why are BHP and Rio accepting only US$78/t? To adjust the price upwards towards something more equivalent would be to add literally billions to the bottom line of both companies.
The answer lies in an arrangement between Australia and China which has been in place for 25 years. For starters, both supplier and customer prefer to negotiate annual fixed-price contracts than play games in the spot market. This provides price security to both parties. But most importantly, under the arrangement Australia has always borne the cost of freight. The Chinese boom caught the world by surprise, and immediately exposed a dramatic shortfall in infrastructure development. Part of that infrastructure is sea-going bulk carriers, and the amount of iron ore, coal, and other commodities being shipped across the world has risen much faster than the rate at which new carriers can be commissioned. And to top things off, the price of oil has risen substantially. Thus the cost of freight has risen exponentially, and it is that difference which determines the ultimate price Australian producers receive for their iron ore – much less than domestic ore and significantly much less than nearby Indian ore at spot.
But the obvious flaw in this argument is Brazil. It might be a long way from the coast of Western Australia to Chinese ports, but it’s a lot further from Brazil – half a world away. On that basis CVRD should ultimately be receiving much less for its ore than Australia.
However the Brazilians argued the toss with the Chinese early in the piece, and as such managed to negotiate a freight cost sharing arrangement. The further iron ore has to travel, the greater the margin of increase on rapidly rising freight costs. In other words, the greater the cost margin of freight from Brazil over Australia, the greater recompense the Brazilians receive from the Chinese. End result – a higher price for Brazilian iron ore.
So the obvious conclusion here is that Australia is in the box seat. China needs Australian iron ore, so it will have no choice but to pay more for it. The increased price should not only involve a demand premium, but a renegotiation of the freight terms as well. This is why Merrill Lynch can see at least a 30% price rise based on current demand, but can also envisage the scope for a 100% price rise on an equitable freight basis. Australia could double the price of its iron ore, and still be the cheapest on the market after Brazil has negotiated its demand-based price rise. There is, however, one small problem.
The Chinese just won’t have a bar of it. This from one recent press report:
“Luo Bingsheng, vice chair of the China Iron & Steel Association (CISA) has said that China will not pay a freight premium for iron ore from Australia. BHP Billiton and Rio Tinto are both expected to ask for more money for their ore in the upcoming negotiations, because its landed cost in China is cheaper than ore from Brazil. CISA anticipates a lengthy and ‘difficult’ round of price negotiations this year.”
Macquarie suggests “Exactly how the negotiations will pan out is difficult to predict at this stage. What seems clear is the negotiations will be long and drawn out and acrimonious (for the Australians)”.
Acrimony aside, Merrill Lynch suggests there will never be a better time than now for Australian producers to play their hand and negotiate a better deal. The global iron ore market will remain substantially undersupplied until at least 2011, the analysts believe, and could even remain so out to 2013 depending on how fast Fortescue Mining (FMG) can ramp up. What’s more, without a substantial rise the Australians (and the Brazilians) are already facing a loss on currency appreciation. Merrills also believes the Chinese steel industry has the room to pass through increased raw material costs to customers.
And if negotiations are unable to reach a conclusion by June 2008, BHP and Rio can sell iron ore on the spot market.
Merrills has played out some scenarios. Brazil will enter negotiations first, and if CVRD successfully negotiates a 50% increase in price based on demand, then this equates to a US$72/t price leaving Brazil. Add US$70/t for freight, and the price to China is US$142/t. If Australia offers a 20% discount to spot, or a 10% discount to Brazil, the price would be US$128/t. Subtract a Australia-Brazil freight margin of US$28/t and we’re left with US$100/t leaving Australian shores. The JPY07 price was US$51/t – hence an almost 100% rise.
This would add US$5.4 billion to Rio’s pre-tax and pre-royalty earnings, and US$3.6 billion to BHP’s.
Back in JPY05 BHP attempted to push a change to contract structure, but was forced to back down when it received no support form Rio. Rio now has a new CEO who is believed to hold a differing view and is prepared to talk turkey.
So now it’s just up to the Chinese.