The growing global hunger for commodities, fuelled in part by rising Chinese demand, has driven up prices for oil, cement, iron ore and many other basic building blocks of modern society. Iron ore is a good example. The contract price of iron ore has soared 65% in 2008, compared with 2007, but Australian mining companies, encouraged by high spot prices, rising demand and limited supply, are asking for a further increase.
End users, on the other hand, are working to secure their access to the all-important commodity. Chinese steel companies, flush with cash, are buying shares in large Australian iron-ore mining companies and in some cases, initiating hostile takeovers as they try to buy smaller mining companies outright.
The fierce tug-of-war on iron ore offers a look into the future, into a world where commodities are scarce and expensive, where buyers get creative in order to secure their sources, and where suppliers fight to protect their interests by keeping prices high and limiting foreign investment.
Anxiety for Steelmakers
Global steelmakers are in a state of anxiety as they await the outcome of annual price negotiations with Australian iron ore producers. The negotiations are critical, because they will determine how much iron ore will cost through April 2009. In a situation that is highly unusual, negotiations for the 2008 contract price for iron ore have already dragged on almost two months longer than normal.
Baosteel, China’s largest steel producer, and Brazil’s Companhia Vale Do Rio Doce – Cvrd, or CVRD (Vale), the world’s largest iron ore producer, reached a consensus on the 2008 annual international benchmark price of iron ore on February 23. In that negotiation, the contract price of iron ore surged 65%, compared with the contract price set last year.
Traditionally, whatever price agreement is reached between a top steel maker and a leading iron ore producer is accepted by the whole industry, whether they are Japanese or European steel mills or Australian iron ore producers.
But this year, the situation is sharply different. Two Australian companies, Rio Tinto Group and BHP Billiton, the world’s second- and third-largest iron ore producers respectively, want a much bigger increase than the 65% that CVRD (Vale) achieved. Their demands partly reflect the freight savings that can be realized by shipping iron ore from Australia to China rather than from Brazil. On May 29, the cost of shipping a metric ton of iron ore from Australia to China was $47, compared with $106 a ton to ship from Brazil to China. But the Australian producers’ lofty demands also reflect the rapidly escalating price of iron ore.
In the past year, the spot market price for iron ore has risen much faster than the contract price, with spot prices for iron ore from India increasing by up to 145%. The spot price of iron ore is now about RMB 1,000 per ton higher than the 2007 contract price, and even if the long-term contract price rose 65%, the spot price would still exceed it by RMB 500 per ton.
Steel makers in China, already stung by a three-fold rise in iron ore prices since 2002, are unhappy with the Australian demand for higher prices. “Chinese steel mills import 250 million tons of iron ore under long-term contract every year, and if the iron ore price increases 65%, the cost for all the Chinese mills will increase RMB 60 billion,”said Hu Kai, an analyst from Umetal, a China-based website that provides iron ore information and analysis. Hu added that the total profit of China’s medium and large steel mills using the long-term contract price was only RMB 140 billion in 2007.
The gap between the two sides is still significant, and negotiations are unlikely to be concluded soon.
The Benchmark Pricing System
Every year, steel makers and iron ore producers negotiate to establish a one-year contract price. In these negotiations, the Chinese steel makers are led by Baosteel, and the mining company side is led by Brazil’s CVRD (VALE), and Australia’s Rio Tinto Group and BHP Billiton. Those are the world’s three biggest iron ore suppliers, which together provide more than 70% of the world’s iron ore. This system is called the iron ore annual benchmark pricing system.
The mining companies sell about 80% to 90% of their total iron ore on long-term contracts under this system, with the remaining 10% to 20% sold in spot transactions, where the price changes daily according to supply and demand. In addition, all iron ore from India is now sold in the spot market, which, as noted, has soared as much as 145% compared with last year. The high spot market prices are helping to fuel the Australian iron ore producers’ insistence on higher contract prices.
Because the main ingredient of steel is iron ore, demand for steel is one of the keys to determining iron ore prices. China has overtaken Japan as the world’s largest steel producer, and it is the world’s largest importer of iron ore. Strong demand from China has helped inflate iron ore prices, and imports are still rising: In the first four months of 2008, imports to China rose 15%, year on year. Altogether, the country imported 383.1 million tons of iron ore last year.
But the supply of iron ore is tight, and high-quality mining assets are increasingly scarce. Established mines are reaching the end of their useful lives, while few new major mineral discoveries have been made in the last decade. Mining companies are struggling to increase iron ore output in Australia and Brazil, while inside China, domestic iron ore production remains low. Supply has also been restricted by a shortage of skilled workers and specialty equipment such as drills, and these shortfalls have slowed the development of new mines. “We believe that in at least the next three to five years, iron ore supply cannot meet the demand,” said Ian Ashby, president of iron ore for BHP Billiton. “What we can do is to increase production as soon as possible.”
According to Ashby, the average investment cost for iron ore exploration has been US$ 57 per ton since 2002, but he said that new iron ore investment costs will increase to US$ 105 per ton in the future.
“The main reasons are the appreciation of the Australian dollar against the U.S. dollar, the rising cost of machines over the past few years, and substantial increases in labor costs caused by a worker shortage,” he said.
As demand continues to outpace supply, prices have risen for six straight years. But in the past two years, enormous profits were earned by iron ore producers from India, because they sell their commodities through the spot market rather than at the long-term contract price. This has made the Australian iron ore producers envious and unhappy. Rio Tinto has threatened to abandon the traditional long-term contract arrangement and sell more iron ore on the spot market, where prices are higher.
BHP Billiton has taken a different approach. Last November, it announced a takeover plan for its rival Rio Tinto, offering to pay about US$145 billion to create a natural resources giant that would vie with Brazil’s CVRD (Vale). It then raised the stakes in February, to about US$173 billion.
BHP Billiton believes the combined company would control more than 30% of global iron ore sales. And the combined company, compared with other small and medium-sized manufacturers, would have lower production costs, enabling it to better compete with other iron ore producers. In addition, the combined company would create an annual US$ 3.7 billion in various synergies, as the two companies could share the same trains, the same railways and the same ports.
But the steel producers are unhappy with the proposed takeover. The China Iron and Steel Association (CISA), whose members include all the large steel producers in China, has made a strong objection to the proposed merger, saying that the takeover would create a“monopoly” in the iron ore market, which would give the combined company too much clout in the annual iron ore negotiations. Currently, Rio Tinto and BHP Billiton account for half of Asia’s iron ore imports.
Chinese Companies on the Prowl
Meanwhile, Chinese companies have moved to acquire more resources. In February, the state-owned Aluminum Corporation of China (Chinalco), which is the largest aluminum company in China, together with Alcoa of the U.S., snapped up 9% of Rio Tinto’s shares for $14 billion, which was a much higher price than the industry had anticipated.
“Buying into foreign mining companies is a way to ensure access to vital overseas resources and possibly to affect prices,” comments Xu Xiangchun, director of Beijing LanGe steel information center.
The purchase puts Chinalco at the center of the takeover bid being waged by BHP Billiton for Rio Tinto, because with the purchase, Chinalco becomes Rio Tinto’s largest shareholder.
Analysts predict that BHP Billiton will initiate a hostile takeover for Rio Tinto, if they get approval from the Australian and UK governments (Rio Tinto is listed in both countries), and possibly the European Commission. They predict a hostile takeover because BHP Billiton’s initial approach was rejected by Rio Tinto’s directors, who said the offer “significantly undervalues Rio Tinto and its prospects.” But if BHP Billiton wants to initiate a hostile takeover, it must get the approval of Rio Tinto’s shareholders, including Chinalco.
Following the lead of Chinalco, more Chinese companies are investing in Australian resource companies. Sinosteel became the first Chinese company to launch a hostile bid in Australia last month, with a $1.2 billion cash offer for Midwest Corp, a Western Australian iron ore miner. “In the iron ore industry, Chinese companies are not only consumers, but we must control as many resources as we can,” said Luo Binsheng, chairman of CISA.
Other Chinese companies are following suit. Australian targets include Midwest, Murchison Metals, Gindalbie Metals and Australian Resources. Most of these are small and medium mining groups, but targets also include large infrastructure projects such as Western Australia’s A$3bn ($2.8bn) Oakajee port and rail project.
Successful Australia Foreign Investment Review Board applications from China rose from 206 to 437 in the year ended June 2006, and doubled again to 874 in the year ended last June. But those figures do not include more recent equity deals, worth about $20 billion since early last year.
But it will be hard for China to gain significant leverage by buying stakes in resource companies in Australia. For one thing, according to Marius Kloppers, CEO of BHP Billiton, even the biggest shareholder might not get a seat on the company board. “According to BHP regulations, directors are selected to the board according to their industry experience, not the number of shares they hold,” he stated.
After three months, although Chinalco has become Rio Tinto’s biggest shareholder, it does not have a seat on the Rio Tinto board, and has little input into the company’s operations. In addition, the Australian government might not be so sanguine about allowing a second Chinese investor to take a significant piece of one of its strategic industries, as it was when Chinalco took its 9% stake in Rio Tinto.
Chinalco’s $14 billion investment in Rio Tinto was China’s largest-ever offshore investment, and it was also seen as a political statement by the Australian media, and a sign that Beijing intends to compete with global resources groups for a seat at the table. According to some Australian media, after Chinalco bought the shares of Rio Tinto, BHP chiefs flew to Canberra for a confidential meeting with the Australian prime minister to persuade the Australian government to deter any further bidding for mining companies by deep-pocketed Chinese interests.
They may have been successful. The Australian government later released a statement of principles, stating that foreign investment had to be in keeping with the national interest. The announcement mentioned sovereign wealth funds, warning that such investors would be subject to greater levels of scrutiny to assess whether their “operations are independent from the relevant foreign government.” State-owned companies, the announcement said, must demonstrate they are in the “business of commerce” and not governed by political objectives.
Australia has already delayed approval of at least 10 Chinese state-owned enterprise deals in the resources sector, suggesting that a slowdown in applications is underway in Australia.
Mei Xinyu, a researcher at China’s commerce ministry, said that 40% of the iron ore that China imported last year was from Australia, and noted that 53% of Australia’s iron ore exports are to China. “For China, we just want to find a reliable supply of natural resources,” he said. “If the Australian government hopes to maintain a long-time reliable market for exports, it is better for them to keep a close relationship with China, not only in the trading field, but also in the investment field.”
Jeremy South, corporate finance global leader for the mining sector for Deloitte, advised Chinese companies to set up joint ventures if they want to invest in a foreign resources sector. “Japanese companies are good examples,” he said. “They have set up many joint venture projects in Australia, and Chinalco also did very well in the Rio Tinto project to find an international partner (Alcoa) to help do the deal.”