Commodities | Jun 22 2006
By Rudi Filapek-Vandyck
At least one commentator has dared to ask the question: will the Chinese steel mills still honour their contracts if the iron ore spot price would fall below the contract price?
It’s a no brainer, really: they won’t.
Already the international business landscape is filled with numerous examples of different attitudes regarding "binding" contracts on both sides of the Chinese border. It would seem Chinese business managers and entrepreneurs don’t see the logic of honouring a contract that is clearly to their disadvantage.
The good news is, however, chances are slim the problem will rise to the surface over the coming months. China’s steel production continues to grow. According to a recent paper by the China Metallurgical and Mining Association domestic growth in iron ore production cannot meet the demand of increasing iron and steel production in the country.
Credit Suisse analysts reported recently the general view of industry players at a recent iron ore conference in Athens was that the projected growth figures regarding China’s hunger for iron ore over the next few years were likely to underestimate true demand.
Even after they finally agreed upon 19% price increase for contract deliveries between April 1 until March 31 2007, spot prices for iron ore remain circa US$14 per tonne higher than imports from Australia still. No doubt this has played a major role in the Chinese finally accepting the proposed price hike.
No matter how unhappy negotiators at Baosteel, China’s largest steel manufacturer, currently are, if the market for iron ore remains as tight as some experts believe it will, Chinese steel mills may face a hard slog in trying to negotiate a price decrease next year. Credit Suisse analysts, for instance, have currently penciled in further price increases of 10% for each of the next two years.
It has to be noted though Credit Suisse analysts currently have few followers in the market with their bullish outlook for the likes of Rio Tinto (RIO) and BHP Billiton (BHP). So far, most experts are banking on no price change for next year (roll over of this year’s contract price).
This doesn’t take away that the 2006 contract negotiations have changed the iron market dynamics, permanently.
The Chinese have taken a public uppercut and they are angry about it. Their determination to avoid a repeating exercise will put them in the driver’s seat at the next round of negotiations.
A fact acknowledged by SB Citigroup’s sector expert Alan Heap. In an update to the broker’s clients, Heap states "These negotiations have established at least one new element. Despite the fact that China failed to set a benchmark price, a changing of the guard did occur. China, not Japan, will be leading Asia’s mills in future price talks."
How can he be so sure about this?
Heap: "Because this year, China will import 320Mt of ore (+15% y-o-y) – almost half of the seaborne trade – while Japan’s share is now a relatively modest 20% (130Mt in 2006). China’s crude steel output is forecast to increase 13% to 390Mt in 2006." (And that last figure may be an understatement still).
As reported in Part I last week, both the Chinese government as the steel mills (largely controlled by the government) are keen to undermine the market power of the Big Three in the sector (BHP, Rio and CVRD). Chinese steel manufacturers have been scouring around the globe to secure alternative supplies and assets. This process will continue.
Part of the strategy is to boost domestic production of iron ore. Heap points out China’s domestic production already increased by a massive 45% to 197Mt in 2005. He says this is forecast to rise further this year by 8.5% to 215Mt.
In addition, the Chinese government may finally force the steel sector to consolidate. The recent negotiations have again exposed several weaknesses in the current industry structure with insiders reporting several smaller steel mills had already accepted the 19% price increase while Baosteel was still trying to achieve a better outcome.
Next time it will definitely be different.
How different will be determined by market developments over the next eight months or so.