China Games the Iron Ore Market

Recent gyrations in the price of iron ore, Australia’s biggest income earner, appear to be inexplicable. However, the fall in ore prices means the government could lose as much as A$25 billion in royalties over the next four years.

Treasurer Joe Hockey has resisted media calls for a government inquiry into the workings of the market, issuing only a short statement confirming that an investigation is off the table. Nonetheless, it appears that China is gaming the market, and that the Australian government is not interested in looking too deeply into why, possibly for fear of the political implications from awakening touchy domestic producers.

While the media has focused discussion on excess supply in the market, that has overlooked a much more surprising feature of that excess supply. It is dominated not by a handful of multinationals but by Chinese producers who are continuing to produce while losing vast amounts of money. Those producers are controlled by government-owned companies willing to take a hit in order to keep workers working at a time when the Chinese economy is starting to sag. It is an indication that, despite Premier Li Keqiang’s continuing crusade to turn the SOEs into rational companies, the government continues to lean on them to maintain stability.

Back in the distant days of September 2012 when the iron ore price experienced its first major sub-A$100 correction, a much different conversation was taking place. At the time there was a general consensus that the iron ore industry had a natural price floor of A$120 per tonne. That was based on the knowledge that China, as well as being the most significant player on the demand side of the iron ore market, was also a significant player on the supply side.

In 2013, Chinese private and state-owned mines were responsible for supplying 25-30 percent of the domestic market on what is called a 62 percent fe basis [fe is the chemical symbol for iron], given that some ores can contain significantly higher concentrations of “penalty” elements including aluminum, water, phosphorus and other impurities. And many of these miners had costs around the A$120 mark.

It was widely believed then that if the iron ore price ever dropped below $120, higher-cost Chinese miners would respond in a textbook fashion and shut down production as steel mills bought superior product on the open market at a lower price. Thus, eventually equilibrium would be restored and the $120 price floor would be maintained.

This belief only partially panned out. While many Chinese mines have either slowed production or shut up shop completely, the aggregate reduction in production so far has been significantly less than anticipated. Some government-owned steel mills are now paying 35 percent above the spot price to keep Chinese mines working.

During 2014, Chinese domestic iron ore production was estimated at 350 million – 400 million tonnes a year on a 62 percent fe-basis. Rio Tinto, the British-Australian multinational metals and mining corporation, estimated that by the end of 2015 Chinese supply would begin to decline and eventually fall to 230 million tonnes. This has not even begun to occur.

So why has China acted in an economically irrational manner?

The accepted conclusion was that the Chinese government continued to support their loss-making state-owned miners because they were significant regional employers in a number of provinces and that this along with the preservation of social harmony were important goals for the Chinese government.

However, this was only one consideration among a host of factors behind continuing support for money-losing Chinese miners. Beijing’s decision to support high-cost domestic operations and maintain an unprofitable supply into the iron ore market has played a significant contribution in the decline of the iron ore price.

It is difficult to quantify the amount of the gains but a look at the cost curve for the global iron ore industry provides some sense of the magnitude.

Source: Reserve Bank of Australia, 2014.

According to the above cost curve the majority of domestic Chinese iron ore supply is under-water or losing massive amounts of money at the current price of $63 per tonne. The figures are likely to overstate Chinese costs but nonetheless provide some sense of how much money Beijing is pumping into the market in order to support uneconomic producers.

The Chinese decision to maintain their high-cost producers has both preserved jobs, maintained resource security and contributed to a decline in the iron ore price. Certainly a brilliant trifecta for a country which has traditionally been a price-taker with this commodity, which remains essential to the country’s development plans.

It is now clear that China’s strategic long-term focus has paid a triple dividend of monumental proportions and has shown what a centrally coordinated authority can achieve even in a multi-billion dollar international market with a host of competing players.

The recent Australian government decision to back away from an inquiry into the iron ore industry means that any meaningful response is looking increasingly improbable. This is not surprising. The last Australian politician to attempt to tussle with the iron ore industry was Kevin Rudd. We all know what happened to him; he ended up losing his prime ministership as a result.

James Blair is a current affairs commentator based in Perth, Western Australia.