China fails to show its mettle

China's early leadership role in annual negotiations to set the price of iron ore underlined its growing influence in commodities markets. But by June, the largest steel producer in the world was two months late negotiating a price, and talk began to focus on Beijing's shortcomings as an international trade leader.

China may be the biggest kid on the block but economic steroids notwithstanding, the world's fastest-growing economy lacks world-class credentials. Internal politics and government interference are still a factor and the only consensus to emerge from what should have been reasonably straightforward negotiations was that China's reach may still exceed its grasp.

Last year's copper debacle – which resulted in massive losses for China and drove up prices around the world – was one example of the country's lack of market savvy. Another was the bet by China Aviation Oil (Singapore) that oil prices would go down; a bet that drove the company into bankruptcy protection. The bumbling efforts in the iron ore price negotiations complete the picture of a country that is still far from realizing its ambition of becoming a commodities powerbroker.

Modest price hike

What is most galling about the iron ore situation is that there was no massive price rise to swallow. In 2005, Japan negotiated a 71.5% hike with the big three iron ore mining companies, which analysts said was needed to bring undervalued iron ore prices to more realistic levels. China expressed significant opposition to the large increase and sent in Baosteel, its largest steel producer, to do better this year.

Early in 2006, iron ore producers were pushing for another price rise, albeit a more modest one than the previous year. While iron ore miners were talking about hikes in the neighborhood of 20% China was vocally pushing in the other direction. Furious after 2005's huge increase, the country took the lead role in the negotiations.

"The rest of the world sat back on the buying side," said Melinda Moore, former chief China representative for Steel Business Briefing. Unfortunately, "they had backed themselves into a corner."

Iron ore is unique in the way it is traded. Unlike other commodities, prices for the majority of seaborne iron ore traded around the world are set annually. Some ore is sold on the spot market – Indian ore being the most visible example – but the largest deals are based on annual contracts.

The world's big three producers, Anglo-Australian companies Rio Tinto and BHP Billiton and Brazil's Companhia Vale do Rio Doce (CVRD), dig up about 70% of the iron ore traded around the world. Every year, a top iron ore buyer negotiates a benchmark price with one of the big three and the rest of the world follows suit.

This was the first time China had been elevated to the status of price trendsetter. Japan, Europe and South Korea, the biggest steelmakers in the world, stood back and waited. Prices are usually set around April 1 but by mid-May there was still no deal. Annual contracts expire at the end of June and mills without a contract may be forced to buy in the spot market. Unwilling to let China lock up their business planning any longer, countries from Asia to Europe began making their own deals.

On May 15, CVRD the world's largest iron ore miner, announced a deal with Germany's ThyssenKrupp AG for a 19% increase. A similar deal with Japanese steelmakers followed on May 17. On May 18, South Korea's Posco also signed up with CVRD while Rio Tinto came to an agreement with Japanese mills. A trend had been set, a benchmark price – 19% – had been established, and in the days that followed, more steelmakers signed up.

Through various organizations and state media, Beijing let it be known that it was holding out for a smaller hike or even a discount and made its unhappiness at the developments quite clear.

"Individual steel groups in the region have been falling like dominoes of late and accepting unreasonably high prices for iron ore," said the China Iron and Steel Association on May 22. "Their concessions are putting undue pressure on the Chinese side to follow suit."

By early June, and with no China deal done, speculation was rampant that the country would have no choice but to accept the 19% increase. It was also claimed that, despite giving Baosteel the green light to lead negotiations, Beijing had tried to dictate terms and conditions. Baosteel declined to comment on the issue but rumors of its frustration with government involvement managed to break through the wall of silence that surrounds Beijing's interference in business.

"It has become highly political and what should have been a fairly simple negotiation has become very complicated," said Moore. "The only ones that haven't come through are the Chinese. The markets seem to keep moving against them and their arguments seem to be more spurious."

Moore believes that, had China acted decisively, the price rise could have been kept down to 15%. That, however, was several months and millions of dollars ago. By June the world had moved on and China was trying to figure a way out of the corner it was in.

The pending challenge was signing an agreement that saved face – or one that was done very quietly. The silence in the negotiations became defeaning mid-June, when word leaked that China had finally agreed on a price, according to one industry watcher. It saves China from paying over the odds for iron ore on the spot market. But its reputation as a negotiator may be beyond repair. "They have basically lost all the clout they had at the beginning of the year to the point where I don't think anybody will bother with them [next year)," Moore concluded.

Too big to ignore

However, the world may have no choice but to pay attention. China's steel industry is by far the largest in the world, producing three times as much as second-place Japan. "Every time our group comes together and makes some predictions [for China] our predictions are usually wrong," said John Fewtrell, head of communications for the Brussels-based International Iron and Steel Institute (IISI). "And by wrong I mean they are usually too low."

In April, the IISI opened a second office in Beijing because it appreciated the need to master the often contradictory figures and opaque statements that characterize Chinese industry, steel included. "China is driving growth," said Fewtrell. "The center of gravity of the steel industry has moved to Asia."

In 2004 the world consumed 1,379 million metric tons of iron ore, with China accounting for more than a third at 543.7mmt. Japan was in second place on 134.9mmt. China's steel production for 2005 dwarfed Japan's output by 349.4mmt to 112.5mmt; the US was third on 94.9mmt. While production in both Japan and the US was marginally lower in 2005 than in 2004, China's actually went up by about 70mmt.

Global steel production is cyclical. Since 1965, production has jumped from 45mmt to 1,129mmt in 2005, with China and India accounting for much of the growth recorded in the last decade. Ironically, since 1973, steel consumption per person has gone down, resulting in a decline in real terms in the price of iron ore.

Global leader

However, in China the numbers are skewed by inefficiency. There are dozens of small steel mills for every large one and the government has outlined plans to close these small and inefficient operations. "It's probably in China's benefit for some of the small mills to go down," said an industry analyst with Australia's Global Mining.

China's steamrolling economy and sheer size give it a muscle no other country has but this may, at the same time, be a liability. "China is a very important customer," said Rio Tinto's Ian Head but "the majority in demand growth for iron ore is coming from China."

The country's need for this raw material may ultimately counterbalance its powerful position as the biggest buyer – in short, the mining companies know China's demand is largely inelastic and this gives them license to increase prices. Therefore, its actual clout may be defined by how it uses its purchasing power and the decisions it makes as a player on the world stage.
As Steel Business Briefing's Moore said, the country has opportunities to take a leadership role but it needs to be able to carry the ball to the finish line. With iron ore, that didn't happen. "The rest of the world was giving them a massive amount of face ? and they messed it up."

India hits the right spot

The majority of the iron ore trade may be in the hands of a triumvirate of world giants but it is the small Indian mining companies that made the most significant inroads into the Chinese market last year. Indian ore traders rode a wave of demand in China, selling more expensive and lower-quality ore to the smaller mills sprinkled across the resource-hungry country.
A report by industry analyst Global Mining, said Indian dealers were the only ones to gain market share in China in 2005. Indian iron ore producers, which account for 11% of global exports, provide 25% of China's ore, while 41% comes from Australia.

Iron ore is generally traded based on annual contracts but, as the demand grows, spot sales are becoming more important, according to a 2004 report by one of the big three iron ore producers, Rio Tinto: "Never have spot sales – those conducted outside the framework of a long-term contract – been as great a proportion of the overall market price and never has the price differential between the two markets been as great."

The party's over

But India's gravy train may be about to come to a sudden halt. The advantages, higher prices and access to myriad small mills in China, may disappear. Beijing is getting more organized and plans to shut down many of the smaller mills scattered around the country to streamline production. The lowered production may cut down China's demand for iron ore by 60 million metric tons. Since the bigger producers buy their iron ore straight from one of the big three, this is likely to reduce the demands made on Indian miners.

Indian mines cannot produce anywhere near the amount of ore that comes from a Rio Tinto, BHP Billiton or CVRD mine. The largest Indian miner produces up to 20mmt, a quarter of the output coming from a single plant managed by one of the big three, said Harry Banga, vice-president and commodities trader for The Noble Group, and a longtime observer of the Indian iron ore industry.
China needs a lot of ore and it needs it on a constant and regular basis. India, despite its production capacity, may just not be able to ensure a steady supply. India "does not have very large scale ports and infrastructure" and this is not likely to change in the near future, said Banga. "There is nothing on the drawing table."

At the same time, many Indian miners may choose to sell their ore at home, given that the price difference between the spot price Indian miners charge and the contract-based price agreed with the bigger suppliers will be closer than before. This year's 19% hike in the price of ore sold by annual contract compares to only a 2-3% raise on iron ore sold on spot deals. "We strongly feel that the premium that Indian ore had will be at parity with the long-term contracts," said Banga.

Steel: an industry in transition

China's steel industry, by far the largest in the world, is hampered by fragmentation and inefficiency. The country represents one-third of the world's steel production but its largest steelmaker, Baosteel, is only sixth in the world. In 2005, it had only one-third the output of top producer Mittal Steel.

Much of China's steel comes from small mills that buy a lot of ore but are generally inefficient. According to state media, Beijing plans to shut down a lot of these smaller mills, lower the country's overall steel production and cut down demand for iron ore by some 60 million metric tons. Critics, however, have been quick to point out that resistance from local governments – which may depend on these mills for economic growth and employment – may make this task a difficult one.

Still, a more efficient steel industry would be the next natural step for China. By closing down smaller mills located far from the coast, the industry is looking to consolidate into a more flexible and efficient unit. In this way it will be able to respond to the market quicker and, hopefully, play a role in how the market moves.

China emerged as a viable steel producer and a significant market for iron ore in the 1980s. In 2003, it surpassed Japan as the world's largest importer of iron ore. Now it is a behemoth three times larger than second place Japan and still growing. In 2005, steel output rose 27%, far higher than the anticipated 10-15%. Analysts predict output this year to go up another 12% despite Beijing's efforts to cool down the economy.

According to a recent report commissioned by Anglo-Australian mining giant Rio Tinto: "The potential of the market in China is far greater but the uncertainty about the path of development is also greater."