Steel Industry Insight

Vale vs. China: The ultimate power struggle

Change is inevitable. In a society where the latest gadget becomes outdated nearly the instant you swipe your credit card, if a product or company isn’t changing and adapting, it will fall behind while its competitors thrive. Corporations and countries are constantly fighting to become the “next big thing” and become more self-sufficient.

World steel production is at an all-time high today, driven by the exponential growth in China’s steelmaking capacity, resulting in many steel producers shoring up raw material resources or even expanding into the mining business themselves to lessen their dependence on outside sources. But no matter how many mining operations steel producers acquire, the global iron ore market is monopolized by three mining giants: BHP Billiton, Rio Tinto and Vale, giving these three companies control over one key factor in the steel world—price.

Contracts then

Up until a couple years ago, global iron ore contracts operated on an annual basis. This annual pricing system for iron ore had been in place since the 1960s, when at the beginning of the year, major mining companies would negotiate prices with their customers, and the first to make a deal set a sort of benchmark for others, and regardless of fluctuations in demand, supply, and steel prices, one thing remained fixed: raw material costs.

But raw materials prices on the spot market rarely remain stable for more than a couple days, much less a year. Nonetheless, up until a few years ago, it was a system that appeared to work relatively well for both parties involved. Then 2008/2009 hit and iron ore prices on the spot market sank to nearly historic lows (as did the prices of most commodities), but contract customers were still paying the high prices set in their contracts at the start of the year, despite precipitously declining finished steel prices—resulting in huge losses for steel mills.

After that, customers demanded that mining companies abandon the antiquated annual contracts and change the pricing mechanism to more accurately reflect spot prices. In China, mills didn’t just insist their iron ore suppliers make a change, they forced their hand by defaulting on their contracts and instead purchasing iron ore on the spot market. In early 2010, iron ore contracts were moved to a quarterly basis, in which contract prices were based on the average spot market price of iron ore during the three months, or quarter, before the month preceding the quarter in which the iron ore would be delivered.

That mechanism also appeared to be working relatively well until iron prices fell 18 percent throughout 2011. Prices sank in October of last year, plummeting 31 percent in just six weeks. And while spot iron ore prices were dropping, steel demand in China cooled and steel prices fell as well. Yet raw material costs once again remained unchanged. So, mills in both China and some in Europe demanded a change to contracts to better reflect the spot market. And when China, a country that imports nearly 700,000,000 tons of iron ore annually and is the world’s largest consumer of iron ore (60 percent of total iron ore imports are sent to China) pushes for change, change becomes inevitable.

Contracts now

In December 2011, Vale’s customers in China and Europe started to seriously pressure the mining company to do what some of its competitors had already done—change the way contract prices are set to better reflect the spot market. BHP Billiton, as one example, already sells under shorter contracts.

Vale’s top iron ore executive Jose Carlos Martins said in an interview with the media in December that “with the recent drop in prices we got a lot of pressure from customers to change…we are more flexible to accept the price reality from the market.” Martins went on to say that Vale would be willing to renegotiate prices with any customers unhappy with the current system. Just a few days after Martin’s statements, news broke that Vale has changed its iron ore pricing method for about 80 percent of its customers, and new contract iron ore prices will be based on the average price during the quarter in which the iron ore is delivered.

A change was unavoidable, according to market sources, but the rapid weakening of iron ore prices in late fall accelerated the move toward a shorter pricing method, and one that more accurately reflected the spot market.

While Vale’s new method doesn’t shield the company from losses if iron ore prices drop again, it does protect the company if prices are rising. Vale warned its Chinese customers wishing to change their contracts that it would be a “one-way street” and if prices do rise again, they cannot move back to lag-time quarterly contracts.

Contracts in the future

In the final days of 2011, analysts began to offer their take on what the next logical step would be, with most agreeing that the current system is just a “pit-stop” to even shorter contracts. Chinese steelmakers will eventually move toward contracts that are based on monthly and even weekly averages, or even just purchasing iron ore on the spot market entirely.

But iron ore being traded only on the spot market isn’t a likely scenario anytime soon, especially for Chinese mills that import the key steelmaking ingredient from a country as far away as Brazil. Iron ore traded entirely on the spot market would result in just the kind of volatility that Chinese mills were trying to avoid and would undoubtedly translate into sharp peaks and dives in steel prices.

No doubt, shorter contracts could very well be where global iron ore contracts are headed for Vale, as China has fought Vale’s near-monopoly of global iron ore trade for some time now. China has been fiercely resisting Vale’s fleet of very large iron ore carriers (VLOC)—which can carry up to 400,000 metric tons of iron ore—that Vale had manufactured specifically for its largest customer in order to cut down on freight costs. But most of the vessels Vale sent to China were diverted to other countries because China would not accept them. In early January 2012, one of the Valemax vessels finally docked at a Chinese port—incidentally just a couple weeks after Vale agreed to switch to shorter iron ore contracts.

Beijing, in particular, claimed that the giant vessels were a safety concern and there were “hidden dangers” associated with the ships. But the more widespread belief was that the Chinese government is simply protecting its own ship owners and carriers. Despite this seemingly positive development, the power struggle between Vale and the steelmaking behemoth that is China isn’t settling down anytime soon.

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