China Challenges BHP Billiton on Iron Ore Prices

“What is the deal with iron ore prices?” we can hear Jerry Seinfeld asking. Aware that prices in the spot market are nearly double the annual contract price, the good folks at BHP (ASX:BHP) are mulling the idea of moving to an iron ore index price. This would give the iron ore market something that characterises nearly all liquid, functioning markets in the world: continuous pricing.

You can’t have the efficient allocation of resources without continuous prices. At any given moment, the price of something reflects all the knowledge of buyers and sellers. That knowledge is imperfect. But the price tells producers how much to produce because it tells them what buyers are willing to pay.

Incidentally, this is why tinkering with interest rates is so disastrous. It mixes the price signals, encouraging producers to spend money based on consumer demand that isn’t sustainable. This results in the misallocation of resources…and overproduction. If you want an example of that, there are nearly 18 million vacant houses in the United States.

High home prices—driven by low interest rates and easy borrowing rules—led builders to produce more than the natural rate of market demand. That’s a lot of wasted copper wiring and sheet rock. It will make for good kindling in the cold winter months, when heating oil can’t be found.

But back to the iron ore market. Why is there no continuous pricing? It’s probably because until recently, the iron ore market wasn’t liquid enough to warrant continuous pricing. There are a few large producers - BHP, RIO (ASX:RIO), and CVRD - and a few large producers (Chinese, Japanese, and Korean steel mills).

It is a large market in terms of dollars, but a small market in terms of participants. Thus, the annual price for iron ore is the product of gentlemanly negotiations between the two parties. Yesterday, Chen Xianwen, the head of the iron ore department at the China Iron and Steel Association, warned BHP that moving to a new pricing system would be ungentlemanly.

“It is dishonourable for one party to violate the code. It us understandable for a new player to break the code but they [BHP] have already been in this game a long time,” Chen was quoted as saying in today’s Sydney Morning Herald.

The gentleman’s agreement on iron ore prices between ore producers and steel mills made sense when the iron ore market was smaller. Price certainty was more important to both parties than a real market price. And certainly, it’s in the interest of Chinese mills to contain ore prices by negotiating them rather than letting them be determined by market forces. But hasn’t the resource boom reached a level of longevity and maturity where the market for iron ore deserves to be like markets for other continuously trade, continuously priced commodities?

Dan Denning
The Daily Reckoning Australia

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