China’s appetite for commodities like iron ore is voracious. Over the last two years, however, contract negotiations between suppliers and China’s steel makers have failed to produce agreements. Clinton Dines, former country president of mining giant BHP Billiton in China, spoke with CHINA ECONOMIC REVIEW about China’s place at the negotiating table and the need for a transparent iron ore pricing mechanism.
Q: What do you make of the news that China is being left out of iron ore negotiations?
A: People generally don’t know quite how this works. There is constant contact between the contract administrators on the sales side, and the buyers. As often as not people will get wind of BHP meeting with Baosteel – oh, they must be negotiating. But frankly, if they weren’t in there a minimum of once a week, something would be fundamentally wrong. You have to recognize that China is going to account for well north of half of the global supply, upwards of 60%. You can’t ignore them. They are the great, giant bull-moose in the middle of the table.
Q: Doesn’t failing to reach an agreement hurt China’s steel makers?
A: Only a limited proportion of what China buys is contract price. There’s a mythology here: When BHP Billiton was attempting to take over Rio Tinto, they were saying, "This is going to make a monopoly." But if you actually break down the supply of iron ore that goes into the Chinese steel industry, about half of it is domestic and half is imported – and of the half that’s imported, BHP Billiton and Rio Tinto together account for about 20%. Tell me that’s a monopoly.
Q: Where does the misunderstanding come from?
A: There’s a lot of this stuff out there because the iron ore price model is unique. For most other commodities you don’t hear anything like this amount of fuss. The price of most metals is set on the London Metals Exchange – it’s a transparent price, it’s up on a screen.
Q: Why the difference for iron ore?
A: It’s got a historical legacy. The Japanese put this pricing system in place in the 1980s, when it was a buyer’s market and no one could really argue. And it was a mechanism by which they effectively subsidized Brazilian freight with the Australians. The Australians supply very little ore to the Atlantic basin. They’re not competitive; it’s too far, the freight costs are too high. The flip side of that should be that the Brazilians wouldn’t supply into the Pacific.
Q: Should be, but isn’t?
A: It is true, except in the Atlantic basin you have a landed cost pricing structure, where the full freight – the actual cost of the iron ore – is calculated into the pricing discussion. In the Pacific basin, the benchmark price system is a contrived system based on the FOB [free on board] price. The FOB prices of the Brazilians and Australians look more or less the same, and we just pretend that the freight doesn’t exist. The Japanese contrived this so they could keep the Brazilians in the Pacific basin and have leverage over the Australians. The Australians were gaining too much market share in Japan, and the Japanese were afraid that they’d end up with a one-source supply.
Q: Where did it start going wrong?
A: It works really well right up until you get a huge new demand variable coming into the equation – like China – and you flip from a buyer’s market to a seller’s market. The sellers who have been most disadvantaged, the Australians, stand up and say, "We have never liked this, and now we have a bit more leverage." What subsequently happened in 2003-2004 probably wasn’t as well handled by the Australians, certainly by BHP, as it could have been. The Chinese were effectively persuaded by the Japanese that the preservation of benchmark pricing was in their interests. To be blunt, the Japanese conned the Chinese.
Q: What has been the effect on China of maintaining that system?
A: China’s fundamental best interest over time is to encourage the development and expansion of their lowest-cost suppliers, meaning high-grade Australian-sourced iron ore. But what they’ve effectively done is encourage the development and expansion of their highest-cost suppliers. In 2008 the Brazilians settled with Japan, and the Australians didn’t follow. In 2009, we had another settlement with Japan and the Chinese didn’t follow. What this tells you is that the benchmark pricing system is effectively dead. It’s still staggering around because these legacy processes take a long time to get out of the way. What ultimately will end up in its place is some sort of index-based, transparent pricing system. That is generally accepted.
Q: Generally accepted by China, too?
A: The Chinese keep saying, "We’re the biggest buyer in the world, we should get a special price." It’s true that larger individual customers always get some kind of break, that’s how customers and suppliers deal with each other. But it doesn’t and won’t happen on a nation-by-nation basis. Australian suppliers have an interest in maximizing their returns, so they’ll want to see a price that’s got a high degree of transparency, reflects true costs and that doesn’t penalize them like the current system does.
Q: What about the impact of rising commodity prices on manufacturers?
A: My impression is that the Chinese government is not as anxious about that. They know they haven’t been getting much rent out of making Barbie dolls. They’re comfortable seeing China’s relative position in the "el cheapo" space begin to evolve because it would imply that general living standards are rising. China is still going to have to import a lot of raw materials, particularly given its stage of development. They’ve got another couple of decades of building, and implied in that is raw material and energy imports. But it implies also over time an evolution toward more comparative advantage – China becoming more focused on where the best economics are.
Q: And what does that mean for iron ore and other commodities?
A: The best decision they can make is to buy cheap ore from the Australians. It also creates a massive incentive for China to appreciate the currency. If you’re sitting in Zhongnanhai, the temptation to appreciate your currency in a couple of big leaps and make all that oil and iron ore cheaper is very high. But their approach is gradualist – you can’t be too disruptive, to the global economy or to the domestic economy – the domestic economy being the 80-90% consideration. Every little incremental shift you make impacts 50 million people.