Paying the price

Thanks to its brisk economic growth, China has emerged as a major buyer in the international commodities market over the years. Now, it has become one of the largest importers of iron ore, oil and wood pulp. Yet, despite the sheer volume of its imports, the nation has little say in the pricing of primary goods. And no other example could demonstrate this point better than the iron ore price negotiations.

China is now the world's largest iron ore buyer and accounted for 46 percent of the international iron ore trade in 2007. Yet, steelmakers only have limited influence over iron ore pricing in the international market. In June 23, Baosteel Group, which represented all Chinese steelmakers, had to agree with a 96.5 percent rise in the long-term contract prices for iron ore in 2008, after its on-again, off-again negotiations with Australia's ore exporter Rio Tinto. The price hike was much higher than those enjoyed by South Korean and Japanese exporters. And it's the largest price hike since China joined the annual negotiations for iron ore price in 2004.

As the 2009 iron ore negotiation are around the corner, Chinese steel enterprises should reflect on the issue and find the answer to an important question: how could Chinese enterprises have a say in the iron ore price negotiations?

China's iron ore imports surged rapidly during 2003 and 2007, maintaining an annual growth of more than 15 percent. Last year, the nation imported 383 million tons of iron ore, or 46 percent of the world's total iron ore trade. During the same period, the nation also accounted for 90 percent of the new demand in iron ore exports. But ever since China joined the price negotiations in 2004, its import prices have been climbing.

The supply and demand relationship could largely explain Chinese enterprises' weakness in the pricing negotiations. Over the past few years, the global economy, as well as the Chinese economy, was on an expansion phase, which resulted in a rising demand of iron ore. But given the hefty investment in global production capacity, the overall supply and demand was in balance.

Yet, it's a different scenario for China. As the nation has limited reserves of high-quality iron ore, it has to import about 50 percent of its total demand.

In the meantime, China's steel industry is highly fragmented, which means individual steel mills have little power to bargain with iron ore exporters. Presently, China has more than 700 steel mills and the largest 10 only accounted for 36.6 percent of the nation's total output collectively. In contrast, the top four steel companies in developed countries usually hold 70 percent of their steel production. Moreover, the world's iron ore trade is controlled mainly by three companies, such as Brazil's Vale, Australia's Rio Tinto and BHP Billiton. And they hold 75 percent of the global iron ore supply.

The pricing mechanism of iron ore negotiations also increases the disadvantage of Chinese steel enterprises. There are two kinds of iron ore prices in the international market: the long-term contract price and the spot price. Usually, the spot price is higher than the long-term contract price but the two kinds of prices are positively related to each other.

The existence of numerous Chinese steel enterprises actually pushed up both the long-term contract price and the spot one. About 45 percent of Chinese iron ore imports are based on contract price and the other 55 percent have to be bought on the spot market. Large enterprises such as Baosteel Group could secure their supply under contract price, while small mills have to buy iron ore in the spot market. Since the excessive demand of China's small steelmakers has pushed up the spot price over the past years, steel makers have to accept the price increases in their long-term contracts.

Moreover, in the price negotiations for long-term contracts, once a price was accepted by a buyer in the first place, the rest of the buyers will have to accept that price as their benchmark. So whenever buyers from other nations agree to a price hike, Chinese companies would have to follow suit. This was the exact situation in the iron ore price negotiations for 2008. In February, Japanese steel maker Nippon Steel and its partner South Korea's POSCO Steel, accepted a price hike of about 70 percent in the long term contract. And then Chinese enterprises had to accept the hefty rise even before their negotiations.

There are three strategies for Chinese industry to obtain better pricing power in the international iron ore market.

First, the government and industry associations should help reduce local protectionism and encourage further consolidation of China's steel industry. The government could encourage enterprises with higher efficiency and larger scale to begin mergers and acquisitions. There are already some cases in this direction but more are needed. For example, Shanghai-based Baosteel Group agreed to form a joint venture with Guangzhou Iron and Steel Enterprises and Shaoguan Iron and Steel Group in Guangdong province in June. In the same month, Tangshan Iron and Steel Corp and Handan Iron and Steel Corp in Hebei province also decided to merge into Hebei Iron and Steel Group Co after five months of discussions.

Second, Chinese steel enterprises should expand into the upstream industry to reduce their dependence on the existing iron ore suppliers. As China's iron ore resources are limited, Chinese steel makers should buy iron ore mines abroad. Presently, only 13.8 percent of Chinese iron ore imports came from the overseas mines owned by Chinese enterprises, compared with 60 percent for Japan.

Third, When it comes to the strategy of negotiations, not only Chinese enterprises should cooperate with each other, but they should also increase communications with steel makers in other nations. Moreover, the government and industry associations should establish a mechanism that encourages Chinese steel enterprises to participate in iron ore price negotiations.

The author is a researcher with Samsung Economic Research Institute. The views expressed in the article are his own.

(China Daily 11/03/2008 page7)