In a recent article for Gavekal Dragonomics entitled ‘Beijing Will Call the Shots in Resource Sector Battle Royal”, Michael Komesaroff (known by most simply as ‘metals man’) reasons, “in the post-commodity-boom world, China calls the tune”. This piece discusses the internal and external sectoral constraints that will continue to cause Beijing headaches in its pursuit of restructuring resource markets. Rio Tinto and its top-tier counterparts endure adept in fending off Beijing’s advances and are arriving to battle with their own gambit, eligible of drawing first blood.
‘The Battle Royal’
Alluding to the recent failed Glencore takeover bid for Rio Tinto, Komesaroff argues that another audacious merger attempt will most likely result in the dismemberment of the Anglo-Australian giant, leaving Chinese state-owned resource companies with chances to cherry-pick from a smorgasbord of resulting businesses. This could mean large movements in the iron ore sector, an area where China has experienced limited success.
Once, the domain of tightly coordinated Japanese conglomerates, hyperactive industrial expansion and urbanisation has resulted in China becoming the global epicenter for steel. Overtaking Japan in 1996, Chinese output now dwarfs Japanese production by a ratio of 7:1, accounting for 50.26 per cent of global figures. China’s experience departs from the Japanese model, in that Japan’s domestic iron ore has always remained negligible. Yet despite boasting the fourth largest ore deposits in the world and representing the largest extractor, China’s iron ore story is not as rosy as one might expect.
The ever-augmenting necessity of ore has led to state directives of “going out” resulting in numerous transfigurations to the iron ore market. Pricing mechanisms have changed from long-term contracts to increased spot pricing and Chinese state-owned enterprises have initiated heavier investment in ore projects. In 2007-08 less than 5 per cent of Chinese investments in Australia were in the energy and minerals sector, in 2008-09 this figure jumped to 98.9 per cent. It was during this period that China’s state-owned Chinalco purchased just short of 10 per cent of Rio’s total shares, making it the largest investor. Since then, a swathe of underperforming investments has left Rio increasingly dependent on its flagship sector- iron ore. Komesaroff argues that Rio’s time in the sun is drawing to its close, as the crash in ore prices leaves Rio brutally exposed. Sour relations as a result of the exclusion of a Chinese representative on the company’s board and a CEO “more at home in London than Beijing” he says, may make ‘victory’ all the sweeter. However, Rio Tinto and its prominent peers (BHP Billiton and Vale) seem entrenched and could actually draw first blood.
‘The Big Three’ & Structural Power
Unlike most other tradable commodities, fundamental norms have been mostly deficient in delineating institutionalised practices in the iron ore market. The current configuration’s origins emanate from Japanese arrangements, which arrived alongside the lifting of an ore export embargo from Australia in the mid-1960s. Since then, three giants increasingly dominated all aspects of the sector. Therefore, when talking about the global iron ore and steel sector it is possible to consider an increasingly polarised landscape of actors.
Unlike the Japanese cartels, China’s steel sector suffers from devolution of governance coupled with geographical dispersion. In 1998, the centre took four state-owned enterprises as their anchor, while those remaining were bestowed to their respective provincial or local governments . Since then, policy objectives incessantly struggle to force mergers and acquisitions, reduce numbers or iron ore and steel smelting plants, and to fight overcapacity. In December 2014 at an industry conference, Deputy Director of the Ministry of Industry and Information Technology’s Department of Industrial Policy warned, “it now appears that the elimination of backward operations is becoming increasingly difficult”. Because local governments protect their local mills, which in turn fight to maintain captive and domestic supply, inefficient ore mines remain open, creating a battle on the domestic governance front and in the international iron ore arena. The sectors are intertwined and riddled with confrontations. Policy for increased domestic ore use and control of ore abroad attempt reduce dependency, currently about 70:30 in favour of imports. In February, Pan Guosheng of Hangking Group warned this dependency ratio would rise to about 81 per cent by 2017.
The Push and Pull
In 2014, China imported 933 million tonnes of iron ore, an increase of 13.82 per cent (129 million tonnes) from 2013. The problems with China’s domestic reserves are low ferrous content and expensive extraction costs. While ore from the top 3 producers is around 62 per cent ferrous content, domestic ore is extremely low in comparison, meaning Chinese miners must basically dig three times as much to retrieve the same amount of ore. Despite plummeting ore prices (now below $60/tonne) Rio’s production costs (shown below) continue to decline while competitors fall by the wayside, the result of which is becoming an even larger market share.
Data: UBS, 2014
The problems with China’s ore are echoed in its steel industry, beyond the structural issues mentioned above the industry profit margin comes in almost in last place when compared with 30 or so key sectors and debt-to-asset ratios are also deteriorating. This has led to iron ore actors enlarging their slice of the pie (shown below). In the face of falling prices, the strategy of the largest miners has been to attack head-on, ramping up production, much to the dismay of smaller-scale actors, both within China and in the international sphere.
Data: World Steel Association, 2013
As Komesaroff alludes, this cycle end is presenting an era of large changes in the minerals sector. What is interesting about this price glut, however, is the local- and industry-level struggle within China to vehemently resist mine closures. Unlike other price slumps, they recognise closing mines would probably mean the end of business for the long-term, a heavy prospect for local employers and governments. However, the gambit of oversupply may already be drawing blood. While steel state-owned enterprises are more defiant in closing captive mines at home, private operations are following the rules of the market (shown below). Ore production began falling in the last few months of 2014, declining 4.6 per cent in December. As prices continue to slide, private operations are closing meaning the Big Three eliminate competition.
Data: BPH Billiton, 2015
Analysts expect Glencore’s next bid to arrive this April when the six-month limitation expires. Will Rio Tinto disintegrate allowing Beijing to ‘cherry pick’ or can the top three ride out the cycle and eliminate ineffective Chinese supply along the way to emerge victorious? April may be a month for movements in the iron ore sector.
Mark Eels is the Climate Change and Energy Security Fellow at Young Australians in International Affairs.
Image Credit: The Gonger (Flickr: Creative Commons)