Iron Ore Negotiations Reach an All-Too-Familiar Impasse

Iron ore negotiations have ground to a halt - again.

Iron ore producers and consumers were so far apart last year that negotiations on pricing broke down entirely. No price benchmark was reached between major Australian iron ore miners and China's steel mills.

Instead, steelmakers resorted to buying their iron ore from smaller producers on the volatile spot market. And they may have to do the same thing again this year.

That's because iron ore producers - led by Brazil's Vale SA (NYSE ADR: VALE) and Australian juggernauts BHP Billiton (NYSE ADR: BHP) and Rio Tinto PLC (NYSE ADR: RTP) - are reportedly looking for an increase of as much as 90% in the benchmark price.

"The negotiations are difficult. These miners hope for a large rise" in the 2010 benchmark price of iron ore, said Deng Qilin, the chairman of both the China Iron and Steel Association and the Wuhan Iron & Steel Group. "We can't digest the pressure of what they're asking us."

Steelmakers Face a "Catch 22" on Prices

Chinese steelmakers like Wuhan - China's third-largest steel maker by output - claim that price increases like the ones miners are asking for will be difficult to pass on to consumers.

"We'll either have to take a huge loss, or raise product prices for downstream users, including automakers, shipbuilders and home-appliance manufacturers," Deng said. "This may cause serious social consequences. There is no good news."

China has more than 1,000 domestic steel mills. It is the world's largest steel producer, and thus the largest consumer of iron ore. The country imported 628 million metric tons of the metal in 2009 - a 42% increase from 443.6 million tons in 2008.

After rising to a record high 570 million tons in 2009, China's steel production may exceed 600 million tons in 2010, according to the China Securities Journal.

However, those figures are winning no favors from the iron ore industry. That's because Chinese steel mills were less than generous with their contract offers when commodities prices collapsed in 2008. Chinese steelmakers used the global recession as leverage to demand a price cut of 45%-50%.

After a few rounds of bitter negotiations, the China Iron and Steel Association turned down an offer of a 33% price reduction from the world's top three iron ore producers - even though Japanese and Korean steel mills were poised to accept the price cut.

China's steelmaking contingent later signed a deal with Fortescue Metals Group Ltd., Australia's No. 3 producer, for a 35% price cut. Just 60% of the iron ore sold to China last year was done so at contract prices, and steelmakers purchased the rest on the spot market. Spot prices for iron ore tumbled 70% from 2007 to 2008.

But now prices have rebounded. Iron ore on the spot market has risen by $10-$15 a ton in the past month alone, reaching roughly $110 per ton. That's about 40% higher than a year earlier, and was double the 2009 contract price.

And with global steel demand staging a strong rebound, prices figure to stay high.

"Seaborne trade is expected to grow by over 100 million tonnes this year, which is twice the average growth rate seen during the past five years,"Goldman Sachs JBWere analyst Malcolm Southwood said in a note to clients. "Supply will inevitably catch up, but probably not until 2011. We expect supply and demand to be much more closely aligned from 2011-12 with potential for an oversupplied seaborne market from 2013-14."

No doubt it's a sellers' market and mining companies are looking to recoup last year's losses, even if that means sidelining China entirely. Vale and its Australian counterparts are reportedly willing to let China walk, and take its chances in the spot market, just as they did last year.

"As far as I am concerned, they [the Chinese negotiators] could come over to Australia if they want to talk," one executive told The Financial Times in January.

True to that sentiment, BHP and Rio are sitting on the sidelines waiting for China to come to them.

"They're not hurried," said Wuhan's Deng. "They're not hurried at all."

Meanwhile, Brazil's Vale has reportedly already abandoned its talks with China, after demanding a price increase between 80% and 100%.

"Vale of Brazil had exited the negotiation for they cannot accept the low prices proposed by Chinese steel mills," a steel producer in China's Hebei province told the National Business Daily.

Vale refuses to comment on "rumors" about iron ore negotiation.

It should be noted, however, that Chinese interests aren't the only ones worried about a stern rise in iron ore contract prices.

The European Confederation of Iron and Steel Industries (Eurofer) warned that sharp price increases could jeopardize Europe's economic recovery.

"European governments should be aware of the implications for the wider economy if these price increases become reality," Eurofer said in a statement. "Increases of this magnitude will have a significant impact on steel prices and, as such, on the whole manufacturing and construction value chain and ultimately on the European consumer. This will reduce demand for many price-sensitive products and therefore slow economic recovery or even push economies back into recession."

Neither BHP Billiton nor Rio Tinto will comment on iron ore prices or their economic impact until negotiations are completed, but both miners have called for a change to the current benchmark pricing system.

A Clash of Iron Wills

Negotiations between iron ore miners and steelmakers are dangerously close to fizzling out for the second year running - and they may be done for good.

Some miners in the past have lobbied to replace the annual benchmark system with a quarterly pricing system based on the spot market.

"For many years we have said that this market has to change, and will change," BHP Billiton Chief Executive Officer Marius Kloppers told reporters earlier this month. "We would love to sign longer term volume contracts priced on an index."

BHP has led that charge by refusing to sign new long-term deals in 2008, spelling an end to all benchmark sales by the end of the decade.

"We are assuming BHP Billiton [will] roll most of its Chinese customers onto index-linked prices," Morgan Stanley (NYSE: MS) analysts said in a recent report. "We understand [BHP] is likely to revoke contracts that have expired due to Chinese steel mills failing to sign new prices in 2009 by the drop-dead date embedded in supply contracts."

The company is "moving away from the annual benchmark price system to ... a spot market that daily sets a clearing price," the brokerage said.

However, BHP's customers are reluctant to follow suit. Some observers think that could change this year, but others are more skeptical.

"The Chinese obsession with trying to argue the iron ore price on a short-term basis from year to year rather than taking a strategic perspective to encourage the expansion of low-cost iron ore capacity has been a major contributing factor to the situation they find themselves in year after year," former BHP Billiton China CEO Clinton Dines, a 20-year veteran of the company and China who stepped down last year, told The Australian.

"The system has cost the Chinese billions," Dines added. "By being short term and bloody minded they encouraged the expansion of high-cost capacity and effectively promoted the spot market, where high-cost producers sell their iron ore. They shot themselves in the foot."

But before accepting higher contract prices or a change to the current system, Chinese steelmakers appear determined to explore one option of last resort: Appealing to China's central government.

More than 10 of the nation's top steel mills have formally petitioned Chinese Premier Wen Jiabao to make the iron ore benchmark price talks "a matter of national importance".

"The domestic steel companies can no longer bear such high quotes of iron ore and have been forced to hike steel prices to pass on the costs," an unnamed source told the China Securities Journal. "Escalating the solution of the iron ore imports issue to the national level can avoid internal friction and protect the overall interest of China's steel industry."

Australia responded this week, asking that Beijing refrain from getting involved and giving assurances that it will do the same.

"We won't be getting involved. I've made the point to China and I repeat the point, we recognize China's market economy status," Australian Trade Minister Simon Crean told reporters in Canberra. "All we ask in return is that it act in accordance with market principles, not seek to get government involved."

However, China's Commerce Ministry said yesterday (Tuesday) that it was preparing a "new policy" to support its steel industry.

"As the world's largest iron ore consumer, the interests of Chinese steel mills should be reflected in the negotiations," Commerce Ministry spokesman Yao Jian told reporters.

Yao did not specify what actions Beijing would take to support China's steel mills, but it could issue preferential tariffs on long-term contracts.

Australian Trade Minister Crean was justifiably irritated at Beijing's response.

"You can't have the government intervene to set prices for what is an internationally traded commodity," he told Australian radio. "China wanted to be recognized as a market economy and what we say is that if that's the case, we have recognized you as a market economy, act like one. Act in accordance with market principles."

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