Our mining madness

I had an interesting chat with an old hand in the coal market yesterday. He described how the in the eighties, as Australian coal producers jockeyed to supply Japan, the annual pricing contracts that determined prices and volumes were a like a Presidential cycle. You’d spend a year negotiating, then agree terms, then resume negotiations the following day for next year.

It was painful and ceaseless but provided essential stability of pricing for the capital intensive businesses at both ends. For Australia it was a boon for the trade account and Budget, also providing predictable export revenues and tax receipts, even though the coal was sold at a discount.

The same annual pricing system existed for iron ore until 2008. Then something happened. BHP and Rio attempted a bold merger. Don Argus toured Canberra and rumours began to spread that unless the merger was endorsed, the iron ore majors might be vulnerable to foreign takeover.

It was all rubbish of course, as FIRB has proved on every second Chinese takeover proposal ever since. The real motivation was to create an iron ore monopoly capable of gouging the Chinese to eternity and back.

Canberra rubber-stamped the idea. Asian capitals – including in Korea and Japan, looked on, incredulous. What had happened to Australia’s commitment to free trade they asked?

When prices collapsed a few months later, the market killed the idea, but still incensed Chinese mills reneged on annual contracts and bought iron or much more cheaply in the spot market.

As it turned out, that was a mistake. By mid 2009, the Chinese own insatiable need for iron ore soon returned the market to supply shortages, and the mining majors refused to return to annual contracts. They installed instead a quarterly pricing mechanism that referenced the spot price much more closely and BHP in particular kept the pressure on for even shorter contracts.

The rest is history. The iron ore spot price soared and Mining Boom Mark II arrived.

I make no bones about being against the BHP/Rio merger. To me it was always on the nose in principle and to my mind, strategically short term thinking as well. The companies themselves are now paying some price. The very unusual Canadian blocking of BHP’s PotashCorp takeover being one example.

Like it or not, however, the outcome of an iron ore and coal pricing system moving towards a floating price now looks inevitable, as Reuters commodity reporter, Andy Home says today:

Vale, which has previously said it was comfortable with its quarterly pricing mechanism, seems to be bowing to buyer pressure. Chinese steel mill sources have told Reuters that the company is offering to price Q4 deliveries against OctoberDecember spot rates, in effect removing the historic time lag.

Vale itself is maintaining official silence on the issue but if it does shift its quotational period, it will be following, again, in the foot-steps of BHP Billiton. Marcus Randolph, head of that company’s ferrous and coal business, told reporters during the recent annual World Steel Association conference that BHP is now selling the “overwhelming majority” of its iron ore using monthly, rather than quarterly, reference prices.

Indeed, it is actively promoting an iron ore trading platform, along the lines of the Global Coal system, as a way of moving iron ore pricing even closer to spot prices. It is clear that the iron ore pricing revolution is still evolving. Quarterly pricing of the sort espoused by Vale, and to some degree by Rio Tinto, always looked no more than a staging post between annual and spot pricing mechanisms. It was a sop to a steel industry that was enraged by the price volatility that followed the demise of the old benchmark system, even if many steel mills were themselves instrumental in causing the revolution in the first place.

The annual benchmark is now dead and buried. Even the China Iron and Steel Association (CISA), which went into a period of public denial that annual pricing had gone for good, has now just launched its own spot iron ore index. Quarterly pricing may be poised to go the same way since it too risks disconnect with the shorter-period pricing that is gaining ever-increasing traction.

So the question we need to ask ourselves is, then, what does this mean? To me the answer is playing out right before our eyes: volatility.

Here’s is yesterday’s iron ore swaps market:

Not surprisingly, after Tuesday’s crash, we’ve had a 2% plus bounce. However, the ore price continues its catch-up, plunging 1.7% through the $150 mark to $147.70. Shanghai rebar also looks to be accelerating to the downside:

In a world dominated by wildcat finance and unstable money flows, as well as perceptions of supply shortages, simple economic theory makes it clear that you should expect just this outcome, booms and busts:

Q0 and P0 represent the initial equilibrium situation in any market. Initial demand is provided by D0, whereas supply is shown as either SR (restricted) or SU (unrestricted).

So, we’ll get higher spikes and lower lows. I don’t know what the overall effect will be on returns although I suspect lower price and volatility would probably win out in the end. What I can say is that the volatility has enormous policy implications.

It may be that the Australian government couldn’t prevent the mining majors and Chinese wrecking the annual contract system. But the fact that they have presents a huge conundrum. Iron ore and coal represent 50% of Australia’s terms of trade, from Rumplestatskin earlier this week:

This kind of dependence resembles (though is not as extreme as) Norway and oil, or Chile and copper, or any number of petro-states. It is no coincidence that the same list of countries heads the list of the world’s largest sovereign wealth funds or, as some call them, stabilisation funds.

The reason why is that although mining companies can endure volatility easily enough, countries can’t. Wild volatility in export and tax receipts is a nightmare in the provision of structural services and expenditure. It is also an unwelcome challenge for every industry group outside of the boom sector via currency and interest rate volatility, as everyone has discovered this year.

If we aren’t or can’t going to manage the key prices in our terms of trade. Then managing the volatile income flows that stem from that failure is essential via a fiscal mechanism like a big mining tax. For a country also supporting a credit and asset bubble, to not do so is crazy.