China Playing Hardball

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It may be illegal (and so is not even officially admitted) but it appears pretty obvious that the Chinese authorities are playing hard ball in their iron ore price negotiations with Rio Tinto and BHP Billiton. Vessels destined for the spot market require licences to discharge, not normally a problem in a country that imports some 40% of its iron ore requirements but only 35% of which are supplied at the long term contract price.

China concluded a contract price with Vale, the world’s largest producer from Brazil, of about USD 76/ton for this year but spot market prices are over USD 200/ton. Rio and BHP are holding out for higher contract prices in their annual round of negotiations on the grounds that it costs less for the Chinese to ship from Australia to China than it does for their Brazilian competitors shipments from Vale. Although the contracts are based on the FOB port of export, the Australians are trying to take advantage of the lower freight rate they know their clients pay when they buy Australian ore. Both Brazilian and Australian quality is much better than lower grade Chinese domestic or imported Indian iron ores, both of which trade for over $200/ton on the spot market in China.

By withholding or delaying licenses most assume China is just trying to send a message to Rio and BHP that they can’t have it all their own way in the price negotiations though in reality everyone knows China will have to settle on a contract price at some stage. The alternative is they continue to pay spot prices at two or three times over the contract price. The major steel mills handle most of the imports so to a certain extent they can pass on the higher cost spot material to their smaller competitors while keeping the majority of the lower priced contract material for themselves.

We came across an interesting article in the Economist the other day which throws some light on this situation. The Economist reported that stockpiles of iron ore at Chinese ports have been steadily growing since August of last year, with a determined rise since the start of 2008. Suggesting that industrial demand in China may be slowing down and explaining how Chinese consumers can afford to be so bullish about stalling Australian deliveries at the ports. Chinese exports of finished steel are down 17.2% since the beginning of this year and tax changes are clearly beginning to bite.

In addition, imports into Europe are dramatically down falling 40% in the first two months of 2008 and 70% since February 2007. No one is suggesting the China commodities boom has hit the buffers but every Bull Run has its dips and troughs along the way. We suspect the combination of slowing western demand, the Chinese governments drive to reduce inflation by squeezing credit and changing tax rules, and rising raw material costs is having the effect of cooling China’s demand. This may not be the harbinger of a price crash but regardless of what happens to iron ore, if steel prices drop even a little, it could be time to restock for deliveries in the second half.

–Stuart Burns

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