By Michael Komesaroff
Moaning about the price of iron ore is an annual ritual for China’s steel producers. But with steel demand collapsing at home and abroad, Beijing is optimistic that it finally has the bargaining power to force the global mining giants to slash the price of contracted iron ore.
If only it were that simple.
China is by far the world’s biggest steel maker, producing more than a third of world supply. Between 2000 and 2008, China’s share of world iron ore consumption increased from a little over 10 per cent to more than 50 per cent.
Because China does not have abundant high quality iron ore reserves, much of the country’s steelmaking capacity is fed by imported iron ore. Three companies – Vale of Brazil and the Australian producers, BHP Billiton and Rio Tinto – control about three-quarters of seaborne iron ore trade.
China, along with other major global importers, buys most of its iron ore under annual price contracts. The price negotiation, an acrimonious process that usually takes up to six months to resolve, is known as the “annual mating ritual”.
For most of the past decade, contract prices rocketed as iron ore producers struggled to keep up with the massive increase in demand driven by China’s apparently insatiable appetite for building materials.
Between 2000 and 2008, price of iron ore more than quadrupled while steel prices rose by less than double. Most of the profits from the huge rise in global steel demand were therefore grabbed by ironore producers, not steelmakers.
But the collapse in Chinese steel demand in the second half of last year marked the end of the steel bull market. Steel production slowed dramatically and a mountain of iron ore stock soon built up at Chinese ports.
Falling demand is the result of two independent factors. First, with 15 per cent of Chinese production exported to foreign markets, Chinese steel producers have been severely hurt by the global downturn.
More important, however, is the collapse in domestic demand. Because the construction industry accounts for more than half of China’s steel demand, there is a strong correlation between steel consumption and building construction.
Last year’s tighter monetary policy and the crackdown on the property sector made it tough for property developers to obtain fresh bank funds, with the result that new projects dried up and steel consumption plummeted.
With Chinese steel demand in freefall and the first drop in iron ore imports on the cards since 1992, some analysts have forecast that steel mills will be able to negotiate a 30 to 40 per cent decline in the benchmark contract price.
But such a sharp price drop is highly unlikely, with a number of market factors likely to limit the expected price cut to 20 per cent.
First, domestic iron ore mines account for about half of China’s iron ore consumption. But falling prices mean that around 30 per cent of the sector is operating with costs well above the delivered price of imported spot ore. According to reports from Tangshan, where most of China’s iron ore mines are located, many of these high-cost operations have shut down.
In addition, falling prices have hit the capacity of smaller international miners to provide Chinese mills with iron ore. Companies like Fortescue Metals and Mount Gibson, which had planned to expand operations, were hit hard by the global credit squeeze.
China’s steel mills will need to replace these two sources of lost capacity with other sources of imported ore, which should help to firm-up contract prices with the mining giants. The fact that port stocksare now down to 45 days of consumption, after exceeding 60 days at the end of last year, suggests that mills are already substituting domestic ore with lower cost equivalent imports.
Second, recent production cuts by iron ore suppliers in Brazil and Australia will tighten supply and reduce pricing pressure. Vale and Rio Tinto, along with several small Australian producers, have announced cuts equal to 10 per cent of their current production.
Third, Beijing’s 4,000bn yuan fiscal stimulus package is aimed squarely at new infrastructure investment, with 45 per cent of the headline package due to be ploughed into railways, roads, airports and the power grid over the next two years.
Of particular note is Beijing’s commitment to spending 900bn yuan on affordable houses in 2009-11, injecting 2.7m new houses into the market annually over the next three years.
Initial estimates suggest that the stimulus package will boost steel demand by 150m metric tons over a two-year period – equivalent to nearly one-third of the country’s 2007 steel production.
There are also signs that policies designed to re-stimulate the housing market – cuts in mortgage rates and minimum down payments, particularly for first-time buyers – are having some effect. Sliding sales volumes in big cities appear to be bottoming out as lower prices and cheaper financing make purchases more attractive.
The upshot is that demand for steel should begin to rebound in the spring just as stimulus spending will be reaching full throttle. With rising demand and tightening supply strengthening their negotiating hand, iron ore companies will likely prolong price negotiations right up to the June 30 deadline.
Increasingly, Chinese forecasts of a 30 to 40 per cent cut to the price of contracted iron ore look wildly optimistic. Those betting that the traditional April moanfest will give way to cheering could be sorely disappointed.
Michael Komesaroff is principal of Urandaline Investments, a consultancy specializing in China’s capital intensive industries.