Swings and roundabouts

The wheel has definitely turned in the iron ore industry and there is no doubt that, on this spin, the producers have the upper hand. It is only doubt about how long that position will be maintained that disciplines them.

This week Rio Tinto's iron ore chief executive, Sam Walsh, told an iron ore conference in Perth that there was no end in sight to Rio's (and its suitor BHP's) protracted iron ore negotiations with its customers. Brazil's Vale, of course, struck a deal last month for increases of between 65 per cent and 71 per cent.

"There is nothing imminent,” Walsh said of Rio's negotiations, "but we are patient people.”

Rio can afford to be patient, as can BHP. There has been no slowing of the demand for their product, nor demand for steel produced by its customers. Spot prices for iron ore keep rising, with the differential between spot and contract prices widening significantly since the Vale deal. The price is now about $US220 a tonne, or more than twice the level of Rio's contract prices.

Rio and BHP are holding out for a higher price rises than Vale, one that better reflects the market price for their product and which incorporates some element of the freight differential between the Brazilian producer and the Australians.

It is not unprecedented for the negotiations to drag on for this long without resolution – in 2005 it took BHP, then holding out alone in arguing for some of the freight differential, until May to agree a price – but it is unusual. Normally once one producer agrees a benchmark price the rest fall quickly into line.

This time there is a slightly different context. Not only has soaring demand for steel in China continued to exacerbate the supply/demand imbalance and forced spot prices into the stratosphere but Rio is a takeover target and has put a lot of weight on its argument that its iron ore business is bigger and better than BHP's.

The higher the price it can strike in these negotiations the more its relative advantage in iron ore would be worth (although BHP's counter-argument is that its carbon steel materials gives it a bigger overall exposure to the Chinese steel industry).

Time is on Rio's side. While much of its output is under long-term contract, with the price reflecting benchmark prices, there are contracts that will expire on April 1 (the contracts coincide with the start of the Japanese financial year).

Rio has already said it will sell up to 15 million tonnes, or about 8 per cent of its ore output, into the spot market this year. Some of that will probably come from the ‘wriggle room' of about 10 per cent usually written into the contracts – Rio could supply only 90 per cent of the contracted amounts and meet its obligations – but if contracts expire it could direct that volume into the market as well.

For the mills, that would be unpleasant, given that they are now in the process of signing their own contracts with their customers. With demand for steel strong, they'd be competing for iron ore on the spot market – and paying $US220 a tonne or more – to satisfy their contracts.

Unless the economies of China and India hit a brick wall soon, the supply/demand settings will only get worse before they get better, and spot prices will inevitably reflect that. Thus Rio probably makes more money in the short term if the negotiations remain at an impasse.

What will restrain it is the knowledge that gouging today while the producers have the upper hand will cost Rio (and BHP) dearly when the wheel turns again. While that might take a while – BHP believes demand will continue to outstrip supply until at least 2015 – the mass of new production under development, production made commercial by the high spot prices, will eventually flood into the market and undermine Rio and BHP's pricing advantage.

That suggests they will push their advantage hard – as hard as the steel mills did during the decades when they had the upper hand – but not so hard as to leave lasting bitterness. They will also argue for a share of the freight differential and a shift towards a different pricing structure with more flexibility and one where prices are influenced by the spot market.

Rio talks of a "hybrid” contract, where benchmark prices could be regularly re-set by reference to the spot market, while BHP has argued for an index-related approach which would allow the producers to differentiate themselves and get differential pricing depending of the quality of their product and the cost of delivering it.

If they can dilute the leverage the steel mills have traditionally had in the market by shifting the weight of contract pricing away from annual negotiations to market-related prices that do differentiate between producers and product Rio and BHP would have won a long-term structural gain.

Provided, of course, that by the time the mills are again "uppermost,” they don't feel the urge for retribution.