Earlier this year BHP Billiton succeeded in its long-running quest to convert the iron ore market from one based on annual benchmark price negotiations to one where the prices are set by reference to the market. It would appear Marius Kloppers is, with some divine assistance, on the verge doing something similar to the pricing of coking coal.

The battle over iron ore pricing was won against the odds, given that BHP Billiton is the number three producer in iron ore behind Vale and Rio Tinto and that they were reluctant and late converts to its campaign. Only the decision by Chinese mills to renege on their contracts when the iron ore price fell during the financial crisis tipped them over the edge.

Coking coal is an even tighter market than iron ore, with the Australian producers accounting for almost two-thirds of the seaborne trade and Queensland’s Bowen Basin, which BHP Billiton dominates, accounting for about half the seaborne trade.

As the dominant producer, BHP Billiton traditionally sets the price in negotiations with the Japanese steel mills, its major customers. BHP Billiton was able to shift those negotiations from annual confrontations to quarterly benchmark pricing earlier this year, but that’s still a step short of Kloppers’ predilection for selling BHP Billiton’s commodities at market-clearing prices. In effect BHP Billiton moved the market from one annual negotiation to four quarterly negotiations.

In the last quarterly pricing negotiations the Australia producers suffered a price cut of about 7 % relative to the previous quarter, although prices remained at very high levels by historical standards. BHP Billiton is now negotiating deals for the first quarter of next year and, according to Japanese reports, is seeking a price rise of about 8%.

That, however, is apparently not all that it is seeking. It wants to increase the frequency of the pricing even further and move the pricing structure to market prices.

Its leverage in the negotiations has been greatly strengthened by the very heavy rains along the east coast, which have severely disrupted production and caused some of the Australian producers to issue force majeure notices. Last month’s rainfalls in Queensland and NSW were between three and four times their average levels.

That is going to make it difficult for the customers to resist a BHP Billiton push for an even more frequent pricing structure — customers who try to hold out for retention of the quarterly pricing regime, or lower prices rises, face being asked to pay a big premium or, potentially, the loss of supply. That is a pretty potent argument for falling into line with BHP Billiton’s demands.

If he can impose more market-related pricing on the mills, Kloppers will have successfully restructured the pricing mechanisms in iron ore, manganese and coking coal. BHP Billiton and other producers are also agitating for a similar shift to market-related pricing for alumina.

The move to market-clearing prices favours the producers in the current environment where China and India’s expanding steel industries have dramatically altered the demand side of the supply-demand equation and where the financial crisis affected investment in increased production.

Had the iron ore producers retained the annual contract negotiations over price the annual lag in price changes would inevitably have left billions of dollars of value on the table relative to prices that move more directly and continuously in line with demand.

Even if supply and demand were balanced or in an over-supply situation, however, the big low-cost iron ore and coal producers are better off because higher-cost production would be removed more quickly from the market, allowing the big producers to offset some of the price reductions with volume gains.

*This article was originally published on Business Spectator

Peter Fray

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