China’s Import Dilemma

China has suddenly found itself buying a third of the world’s iron ore at prices far below those of its domestic producers although they can still make money. But if prices fall a lot further, they will make nonsense of attempts to reduce import reliance. Ore quality is also an issue. Should it seek to protect itself from over-reliance on foreign iron ore, most of which comes from Australia and Brazil? Or should it welcome the steep fall in prices as helping its trade balance, lowering inflationary pressures and helping a domestic steel industry stressed by huge overcapacity.

The issue is crucial not just for global iron ore exporters and China’s steel producers but also for the bulk shipping industry given that China imports 800 million tonnes a year out of global iron trade of 2.1 billion tonnes.

In recent years Chinese companies, at the urging of the central government, have been active in investing in new iron ore projects in Australia and Africa, partly an outcome of the zeal to use its foreign currency riches to play an international investment role and partly to secure future supplies and avoid another price escalation – in 10 years between 2001 and 2011 the price of internationally traded iron ore rose from US$11 a tonne to a peak of US$179. It has since traded between US$100 and US$150 but most recently been sliding, to US$121 in February, as new production comes on stream, concern about China’s apparently falling economic growth rate, and tighter monetary conditions impacting stockpiling.

Despite the price fall, shipping rates have risen as the surplus of bulk carriers has been reduced and because China’s imports have remained strong. This apparent paradox is explained by the likely fall in China’s own high-cost output.

Cheaper foreign ore is putting pressure on China’s domestic producers where deposits, though large, do not match the high iron content of some overseas ones, particularly the hematite mines in the Pilbara region of western Australia. Already China imports about 70 percent of its needs and the percentage would likely rise if market forces have their way.

New mines being developed in Australia have cash costs of as little as US$20 a tonne so once the rail and port infrastructure is in place it will pay the companies to maximize production even at the cost of driving down the price, eventually perhaps to US$50 a tonne.

The same applies to Brazil, where production is also being ramped up. The longer shipping distance from Brazil adds to landed costs in China, a problem exacerbated by China’s refusal to allow the giant ore carriers built for Vale, the Brazilian ore giant, to enter Chinese ports – a blatant protectionist device to protect China’s shipping companies which do not have such vessels.

China’s protectionism may in future also be applied to iron ore itself. Worried about over reliance on imports, a reliance which is likely to increase due to relative production costs, China is to form a large domestic mining group under the wing of Ansteel Mining, a state owned company which is the largest local producer. The aim is to consolidate iron ore mining currently split among many companies, mostly producing less than 10 million tonnes a year.

Consolidation will be difficult as it will run up against provincial and county level ownership interests. And no amount of consolidation and efficiency gains can compensate for the fact that ore quality is generally much lower and transport costs from mine to mill can be higher than shipping from Australia to ports close to mills.

The alternative tactic to improve its leverage in a market long dominated by the Anglo-Australian giants BHP and Rio Tinto has been to encourage Chinese invest in new projects in Australia, Africa and Canada and do deals with other newcomers to the scene such as Australia’s Fortescue Metals in which Hunan Valin Iron & Steel is a major investor, is close to tripling production to 150 million tonnes a year.

But China’s experience has not been an entirely happy one. The largest investment, by Citic Pacific in Sino Iron, now a US$9 billion project in western Australia, has finally started production but far behind schedule and after massive cost over-runs. Metallurgical Corporation of China and Sinosteel Midwest both had big ambitions in Australia but projects are now on hold due to cost issues. Anshan Steel has run into problems with an investment in the Karara project, also in western Australia.

Meanwhile in Brazil Vale is aiming to raise production by 50 percent from its current 300 million tonnes, Rio continues to expand with production expected to rise this year by 10 percent to 290 million tonnes and BHP by a similar percentage to 220 million tonnes. Expansion is also underway at minor exporters such as Canada and South Africa. In Africa China’s Chalco is partnering with Rio Tinto in a major project in Guinea, Tianjin Minerals has a large stake in a mine in Sierra Leone now being expanded to 35 million tonnes a year and Chinese companies are providing infrastructure and an offtake agreement for a project in Cameroon.

For sure, global demand is still rising despite doubts about China and the chaos in the Indian mining industry, once a significant exporter. Costs have been rising everywhere and few mines can have cash costs as low as those in the Pilbara. But the scale of expansions in train in Australia and Brazil seems likely to produce a very significant surplus which will inevitably drive prices down for a sustained period.

China’s own investments will have an impact too as China’s mills will use China-linked mines as a bargaining tool to reduce the pricing power of the big three. How many Chinese mines can survive at those prices unless subsidized by local or central governments is anyone’s guess.

It should not be forgotten that it was China’s sudden surge in demand from about 2003 which drove prices skyward and spurred the massive investments now still in train. Investments in infrastructure take long to complete but once in place underpin long term production at low costs. In the previous cycle prices were stable at a mere US$11 a tonne for some 20 years before they began their huge upward move in 2003. That is about US$25 in today’s money. As of now they seem unlikely to fall that far as new mines come on stream, but the further they fall below US$100 the harder it will be for China to sustain its own output let alone meet the ten-year goal of cutting imports to 50 percent of demand. That at least is good news for low cost ore exporters, steel users – and the shipping industry.