Spot prices for gold and iron ore have shot up on the back of China's construction boom, challenging the tradition of price benchmarking, writes John Garnaut.
Advertisement AdvertisementHuangdao was once a forgotten fishing village, a short ferry ride from the beer and beach town of Qingdao. Now, a dozen years later, it is Australia's entry point to the world's largest and fastest industrial revolution. Every 12 hours, Huangdao's waterside workers handle enough iron ore to make the steel coat hanger and support beams for the Sydney Harbour Bridge. That's 50 million tonnes of ore - 625 harbour bridges passing each year through the world's largest and most efficient iron ore unloading terminal. And yet Huangdao accounts for just one-sixteenth of China's total iron ore use.
This year China will need enough ore to make enough steel to build high-rise apartments for 19 million new urban migrants, produce 8.5 million cars, complete 17 major city airports and roll out tens of thousands of kilometres of railways, tunnels, bridges and elevated highways. As Phil Mitchell, Rio Tinto's iron ore development manager, likes to put it: "China is building from scratch a city the size of Brisbane every month."
And yet this country of 1.3 billion people is only now entering the most resource-intensive phase of its urbanisation and industrialisation - a revolution that could keep rolling on for another three decades. Car production is rising 46 per cent a year. Fixed-asset investments (such as factories and bridges) account for nearly half of China's GDP and are growing at 26 per cent.
Figures such as these explain why spot (non-contract) prices for iron ore and coal - the two core ingredients of steel - have risen 71 per cent and 38 per cent respectively this year. China's iron ore imports have risen eight-fold in just eight years. China has doubled coal consumption in five years, turning it from exporting to importing and pushing up prices paid by Australia's key coal customers in Japan and Korea.
As luck would have it, Australia exports more coal and iron ore than any other country. The resulting improvement in our export prices has added an extra percentage point of national income in each of the past four years (and will probably do the same this financial year) - without us having to do a thing. It explains why Australia's sharemarket is booming and the country is enjoying the greatest and longest stretch of prosperity it has known. "Australia has never seen a terms-of-trade boom of this magnitude for this length of time," says David Rumbens, a director of Access Economics.
China's extreme appetite and Australia's generous endowments also explain why China's President, Hu Jintao, recently spent a week touring Western Australia, Sydney and Canberra despite preparing for his most important political showdown in five years - the 17th Communist Party Congress. If there's anything that could force China's engineer-president to focus his mind here, it is that China desperately needs Australian resources as cheaply as it can get it.
And if there is anything that drives an Australian mining executive, it is the painful memories of being beaten into submission, year after year, to accept appalling contract prices in the days when resources were still thought of as "old economy". One mining veteran says: "There have been a lot of things that have been imposed on us sellers for decades, which now we can redress."
The upcoming iron ore contract price negotiations between Australia and China will be a showdown between the world's most efficient miner and its greatest manufacturer. It is a contest of national pride, executive ego and billions upon billions of dollars. "It will be compelling viewing," says one participant.
Already, Chinese steel makers and politicians are openly warning the world iron ore "cartel" against destroying Chinese industry. China's official Xinhua news agency says it best: "In view of the damages the monopolistic position of the three iron ore mining giants has done to China's steel industry, Chinese enterprises should keep alert, experts suggest."
In past years Australia's big miners have passively received the blows. This year is different. New chief executives at BHP Billiton and Rio Tinto have taken a more aggressive stance aimed at capturing a premium for Australia's freight-cost advantage over Brazil.
Australian mining executives are well aware of their new-found bargaining power. They are using ungentlemanly words like "blood" and "bodies". They say they will tear apart a global negotiating framework that has been in place for 40 years - if that's what it takes to get a fair deal.
The world's 880 million tonnes of traded iron ore is governed by a quaint system of convention and tradition. When Brazil's Companhia Vale do Rio Doce, the world's largest ore exporter, strikes a deal with a major European or Japanese steel mill, it sets a benchmark annual contract price for the Japanese financial year, which begins in April.
CVRD and the world's second- and third-largest ore exporters, Rio Tinto and BHP, then set nearly all of their contracts at or around the benchmark price. The contracts can guarantee deliveries for as long as 25 years, with the price renegotiated each year.
For most of the past 30 years, the price-setting experience has been a miserable ordeal for Australia's miners. "You'd be sitting in the hotel, waiting to be summoned to the Nippon Steel office," says one veteran. "Then the phone would ring or the fax would clatter and you'd go. They'd tell you what they'd pay and more or less that's what you'd get."
In this executive's view, Nippon Steel was the ringleader of a perfect buyer's cartel. But that was before hundreds of China's steel makers rose from nowhere to dominate the world. "This is the beginning of a new era," says one participant. "Anyone that tells you the scenarios are predictable are just lying through their teeth."
Last year, for the first time, CVRD set the world benchmark price with China's biggest steel company, Baosteel. Negotiations started in November and were settled by Christmas. The Australian miners are still livid that CVRD settled so quickly for a price rise of "just" 9.5 per cent.
This time, will it be Europe, Japan or China that strikes the first deal with CVRD? Will the Chinese producers stick together? And will Rio and BHP follow or chart their own course? The miners are both more consolidated and less united than at any time in recent memory. Nobody, least of all the participants, has any idea who will lead who or where they will go.
The rising cost pressures for Chinese steel producers are in plain view down at the Huangdao. The iron ore unloading dock is serviced by a freight railway and eight-lane road, jammed with an orderly line of empty trucks waiting for their loads. On one side of the road are neat, brightly coloured 20-foot containers, stacked like Lego blocks as far as the eye can see.
On the other are nearly two kilometres of neat mini-mountains of iron ore sorted by iron content, rock size and chemical content. Some consist of the blood red lumps of the Pilbara's Mt Price, others the dustier "fines" from the Carajas region in the Amazon basin.
The port's leaders are old-time avowed communists, who eat plain steamed buns for lunch and dress like Chinese truck drivers. The workers are all sent for military training and instructed in the "1950s" values of integrity, hard work and loyalty to the Communist Party of China.
The management seems incongruous but, for China's steel makers, Huangdao, in north China's Shandong province, is something of a sanctuary in a sea of extortion. At every other link in the supply chain, the steel makers are being punished for their success.
Benchmark contract prices from Australia and Brazil jumped by 9 per cent in 2003 then 18.6 per cent, 71.5 per cent, 19 per cent and 9.5 per cent this year. On top of this, spot market freight costs from Brazil have risen to exceed the cost of the cargo this year because ship builders have not kept up with the huge rise in iron ore and coal exports.
Nor have they anticipated that inadequate Australian infrastructure has forced a large portion of the world's bulk carriers to idle in queues off the coast of Newcastle and Dalrymple Bay. At Newcastle, the world's busiest coal port, the average waiting time has been 30 days this year - when the Australia-China journey takes just seven to 10 days.
Chen Xinnong, a Huangdao port executive, estimates it will take two or three years for ship builders to catch up with demand unless the US economy falls in a deep enough hole to slow the growth in global trade.
And that's how it is for the lucky steel makers - those who are large and influential enough to secure long-term contracts at $US50 a tonne with the likes of CVRD, Rio and BHP. Others must ride the spot market. There, Indian exporters, Chinese miners and legions of intermediaries are charging as much as $US160 a tonne for often sub-grade ore.
The market is so heated that Chinese miners are reportedly using ore with an iron content of just 10 per cent compared to grades of more than 60 per cent in Australia and Brazil.
The Chinese press has carried stories of steel makers being stranded with rubbish ore from the spot market. Shandong customs authorities have reported Indian ore that was delivered with below-grade iron content and full of bricks, plastic bags and water.
And then the steel makers still have to get the ore to their inland blast furnaces. Trucking prices to central Shandong province have jumped by 40 per cent this year, as truck drivers navigate a government road safety crackdown.
Trucks that once carried 90 or even 100 tonnes are now forced to carry just 40. Another proprietor, who would not give her name, said there were 15 police checkpoints on the 90 kilometre road from Zibo, central Shandong, to the provincial capital of Jinan.
"Now we have to use three trucks to do what one used to do," says the boss of a small freight broking company called Zibo Tongshun. "So much to move but so few trucks," says another freight broker.
One truck driver says police were pulling overloaded trucks off the road - until drivers paid bribes to have them released. Another, from a Jinan trucking company, says he got through the checkpoints with little fuss because his company had centralised bribe payments through the local police station. "The police just look at the company name and wave me on," he says.
On top of this, Chinese regulators are trying to shut down small producers, restrict import licenses and curb steel exports by levying steep export taxes.
In this context, with Chinese steel makers already coping with a doubling of input costs in a few short years, BHP Billiton and Rio Tinto are aggressively pushing for yet another huge contract price rises and a potentially huge freight premium in future long-term contracts.
While the contract price for Australian ore and Brazilian ore is roughly the same, BHP is angling for a "freight equalisation" premium because Chinese steel makers pay more for Brazilian freight costs.
The established system of buyers paying for iron ore freight was started by Japanese steel makers as a means to subsidise Brazilian producers and introduce competition against an otherwise Australian monopoly. Japanese steel makers have been relatively unaffected by this year's freight cost surge because they tend to supply their own ships. China has not been so lucky, simply because its rapidly growing fleet has not kept pace with its extraordinary demand for bulk commodities.
According to the UBS analyst Glyn Lawcock, the freight price difference between Australian and Brazilian ore has leapt from a historical average of US$5 a tonne to US$40.
HSBC's Paul McTaggart goes further, arguing that China would save $US2.4 billion if it captured all of the increase in Australian ore production next year rather than paying the extra freight costs for Brazilian ore.
This week BHP's marketing president, Tom Schutte, told analysts he would sell some of the company's expanded iron ore production on the spot market if Asian steel makers refused to meet the freight cost demands.
"A certain percentage of our expansion tonnages will likely be allocated towards [the spot market] if we don't find a [freight differential] mechanism that reflects true supply/demand fundamentals," Mr Schutte said.
Observers say it's no coincidence that BHP's new chief executive, Marius Kloppers, previously held Mr Schutte's marketing job and pushed unsuccessfully for a freight levy in 2005.
Last week Rio Tinto's chief executive, Tom Albanese, seemed to endorse the freight cost argument. "Certainly it hasn't escaped our notice," he said.
So far, however, Rio is stopping short of making threats. If the past is any guide, China's steel makers, politicians and diplomats will be outraged by BHP's freight ultimatum, although reaction has so far been muted because of China's week-long national day holiday. Last month the China Steel Industry Association said "China's steel enterprises will never accept" any sort of freight premium.
How will it pan out? Many analysts have said this week that BHP could win its campaign to up-end the 40-year contract pricing system and introduce a freight premium - if Rio falls in behind BHP. Indeed, some say BHP's freight campaign is directed more at Rio than China.
Says one source close to BHP: "The key to this is how does [Rio] behave. If they find some guts, it will be bloody but the Chinese will go down. If not, they'll win."
Rio is not sending back the signals that BHP would like to hear. "What's the idea - that we should be acting in concert with BHP and ganging up on them?" asks one company source.
Jim Lennon, the director of commodities and mining research at Macquarie Bank, is keen to pour cold water on the whole freight cost argument. He says that less than 10 per cent of Brazilian and Australian ore is carried at high spot market rates and the rest is locked into cheaper long-term freight deals.
Lennon tends to view BHP's argument in rhetorical terms - simply aimed at squeezing the highest possible contract price. "All it gets down to is the iron ore price and it needs to go up," he says.
After the fireworks, he says the big three miners will move to establish their own warehouses in China to sell to smaller steel makers on the spot market. But they're not about to jettison the benchmark system that has been in place for 40 years.
"The more I think about it, the more I'm not convinced they're going to do away with the benchmark. They respect that the benchmark has worked for 40 years and it is the best way to run the business," Lennon says.
He is likely to release a new research report next week that will revise his iron ore price rise forecast of 25 per cent. He would probably be more comfortable with a figure of twice that magnitude.
In the end, as always, concepts of "fairness" will have nothing to with what Chinese steel makers will pay for Australian ore. It will come down to supply and demand.
Zhang Changfu, vice-president of the China Iron & Steel Association, says steel makers are being squeezed by cost pressures. But the facts seem to be against him.
Last month, Xinhua reported figures from Zhang's own association showing China's 77 biggest steel makers increased their sales revenue by one-third to 1.1 trillion yuan in the first seven months of this year compared with the year before. Incredibly, after-tax profits were reported to have risen by 91.5 per cent.
Away from the heat being generated in China and Australia, analysts seem to think China's steel revolution has a long way to run. Jae Jun, head of research at Franklin Templeton Korea, said the world's steel makers still had pricing power and were simply passing higher costs onto downstream manufactures.
"Demand for steel products is strong due to the increasing demand for infrastructure and construction in Asia, Middle East and other emerging markets," he says. "The supply for steel is also increasing but not fast enough to catch demand growth."
Steel and iron ore supply may be increasing, but demand is shooting through the roof. The good money is being put on a price rise in the vicinity of 50 per cent this year - enough to almost guarantee that Australia sails through any American economic downturn.
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