Rudi On Thursday

This story features FORTESCUE LIMITED, and other companies. For more info SHARE ANALYSIS: FMG

(This story was originally published on Wednesday, 26 August 2009. It has now been re-published to make it available to non-paying members at FNArena and members elsewhere).

Colleague Greg attended a meeting of mining executives last month and he reported that everything that seems on the industry’s mind these days starts with a C and ends with “ina”.

China, China, China, China.

I have little doubt whether it is any different for any investors in hard commodities.

Any attempt to describe China’s role this year for most natural resources would only amount to a grave understatement, so I won’t even try. But what has similarly become very obvious is that Chinese authorities are finding it hard to match their importance for the demand side with a corresponding role on the side of supply and price-settings. In other words: China is discovering it is far easier to govern a multi-layered, but one-party controlled one billion-members society than it is to convert an increasingly less-fragmented, international marketplace of producers and suppliers to its own rule(s).

Before we start dragging this into the wrong framework: it is only natural to aim for control once you have become the dominant force of anything. This is why McDonald’s puts local suppliers on paper thin margins and why supermarket duopolists Coles and Woolworths do the same with theirs. China, however, aspires to do the same with base materials, but it has been a tough and disappointing learning curve.

This frustrates those who are in charge of tomorrow’s new superpower. This is why recent commentary in Chinese government-guided newspapers has turned vitriolic towards Australia. Let there be no mistake: China is not going to give up in this battle.

The recent deal with upcoming iron ore producer Fortescue Metals ((FMG)), in which China achieved a larger price discount than the three leading producers were willing to concede, is widely touted as a face saving exercise for CISA (China Iron & Steel Association), the Chinese negotiator who has failed to achieve much more than frustration and disappointment for China’s steel sector. There is certainly an element of truth in this, but the Chinese are also masters in taking a longer term view.

Investors might like to think otherwise, but the iron ore market is not going to remain as tight as it is today forever and ever. The day will come when the market pendulum will swing back to the end user and when that day comes, China will try to use everything in its power to get pay back for the frustration it is enduring now. A much larger Fortescue, largely financed by and thus indebted to Chinese companies, might become the all-important swing producer in an oversupplied iron ore market in two-three years’ time.

That is the scenario Chinese authorities are banking on. That is also the day the Chinese are looking forward to.

It won’t be easy though. As Chinese authorities have learned the hard way this year, a global marketplace contains many more factors than just producers and end users trying to come to a price agreement.

What is much more important than any deals the Chinese can sign off on – be it with Fortescue or with any other producer, including the three industry leaders – is the cost level at which Chinese producers can process and deliver their ore. It is well possible that the negotiators at CISA did not fully appreciate this. It is also possible that the accusation towards Rio Tinto ((RIO)) negotiator Stern Hu and three other staff members of stealing industry sensitive information includes information about these costs.

China might like to have it differently, but its own supply is at least as important as its demand for ore. And Chinese producers cannot match the quality, nor the cost levels of the big three producers.

This, in essence, is why China has failed to pull this year’s price negotiations into its own favour and why international producers, despite agreeing to some sizeable price cuts, are the real winners in this year’s price battle.

In the present context China’s domestic producers have become the all-important swing factor. When spot prices tumbled in the second half of last year, from dizzying highs above US$200/tonne until a bottom of around US$64/tonne in early 2009, China’s domestic supply all but dried up – because at that price Chinese producers could no longer supply steel furnaces without making a loss.

The result was that international demand soared. It all went to China.

It is thus not difficult to see why industry participants were happy to refill their inventories. Everyone at the coal face (so to speak) with enough experience and insight into this dynamic would have understood that prices would go up, or otherwise Chinese domestic production would never restart again.

By now, however, spot prices have again risen to around US$120/tonne in July. They have fallen a few dollars since.

Does anyone know what this means for domestic production in China? I am sure you already guessed it: domestic supply is back. Combine this with full inventories and it is not difficult to see why experts believe iron ore spot prices have just one way to go from here: down.

At face value this seems exactly what the Chinese steel sector would want to see. But why then are many of China’s producers agreeing to the price cuts negotiated by their Japanese and Korean peers? (And which Chinese negotiator CISA has refused to accept, holding out for deeper cuts?)

Because if the spot price falls too low again, domestic production will once again cease. This will boost demand for international shippings and thus boost the spot price. It is probably a fair assumption that Chinese steel companies, who are experiencing this dynamic from a much closer distance, have little hope that any price falls in the weeks ahead could possibly compensate for the fact that they will have to buy in at higher price levels again later.

This year’s highly contested Japanese benchmark price plus freight puts the price of imported iron ore at around US$74/tonne. What are the chances we will see spot at US$64/tonne again? And if we do, will this really be to the benefit of Chinese end users, or will it rather work in the leading producers’ favour?

This is why BHP Billiton ((BHP)), Rio Tinto and Vale have been in no hurry to do any concessions to their Chinese customers – because regardless of the global economic downturn, market dynamics are still working into their favour.

All this shows exactly what a gargantuan task the Chinese are facing in their quest to break the Big Three’s stronghold on one of the key inputs for their economic development. Under a worst case scenario, the next thing to happen is for steel mills in Europe and the US to start adding to global demand. That would really pump up the frustration in China.

It’s not difficult to see why investors have turned increasingly positive on near-term forecasts for iron ore and why experts are starting to revise their price forecasts for next year. Previously, another price fall in contract prices (if the present system remains in place) seemed but a given. Now, it is well conceivable that this year’s price fall might be followed up with another price increase next year.

This party is not going to last forever. However, judging from the present market dynamics, it is unlikely to end soon either.

With these thoughts I leave you all this week.

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by the Ab Fab Team at FNArena)

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