The galvanisation of Rio

In the early part of last year Rio Tinto was on its knees. It was choking on the debt taken on for the ill-timed Alcan acquisition, being hit by tumbling demand and prices for its commodities and was about to be controversially bailed out by China's Chinalco. It ended the year with booming production, a balance sheet stabilised without Chinalco's assistance and the prospect of a value-creating merger of its Pilbara iron ore business with BHP Billiton's.

The remarkable aspect of today's Rio final quarter production report is the contrast it provided between the way Rio was travelling in the early part of 2009 and the way the year ended.

Nowhere was the miner's sea-change in conditions and prospects more evident that at the heart of its portfolio, its iron ore business, where it ended the year with record production and sales and where the surge in production in the second half of the year enabled it to break its quarterly and annual production records and, in its Pilbara system, operate consistently above its nameplate capacity of 220 million tonnes a year.

While there was no benchmark pricing deal with Chinese steel mills last year, most of the surge in production would presumably have been delivered at the same price the producers agreed with the Japanese and Korean mills, about a 33 per cent reduction from the record prices set in 2008.

The ramp-up in production as the year progressed, however, augers well for 2010. The Chinese response to the crisis – a massive injection of financial stimulus into its domestic economy – has ignited steel production and demand for iron ore. Imports of iron ore in December were the second-highest on record.

While there might be an element of stockpiling in anticipation of another lengthy confrontational stand-off with the producers over pricing, surging demand and spiking spot prices do reflect a rebound in the Chinese economy that has been so strong that the Chinese are now tightening monetary policy to try to bring it under control.

The strength of demand – there is an expectation that China's steel production next year will be at record levels – has caused analysts to forecast price increases for iron ore in 2010 that range from 20 to 50 per cent.

Spot prices are, according to Bloomberg, about 80 per cent above the 2009 contract prices, although the spot market is relatively thin and provides only directional relevance for the major producers. It does indicate the strength of the recovery in demand.

While Rio did sell about 15 million tonnes into the spot market in the early part of last year – largely because Chinese customers were reneging on their contracts and buying in the spot market at prices below the benchmarks in their contracts – most of the Rio and BHP output is delivered to contract customers. That will remain the case for the foreseeable future.

The 2010 benchmark prices are, however, clearly going to rise quite sharply. The question is by how much.

At this point, there is no indication that negotiations of any substance between the producers and the Chinese have started, indeed the producers appear to be in no hurry at all to start discussions and the Chinese appear in disarray.

Last year's attempt by the China Iron & Steel Association, which replaced Baosteel as lead negotiator, to impose bigger price cuts on the producers than those agreed with the Japanese and Koreans, failed embarrassingly, with no formal agreement but the mills quietly dealing on the same terms as the Japanese.

It would appear the Australian producers will probably again negotiate a deal with the Japanese first and, without or without a formal benchmark price with the Chinese mills, supply them on the same terms.

The wild swings in demand and pricing over the past year tends to support the BHP Billiton advocacy of mechanisms for establishing more regular pricing at arm's-length from producer/customer contract negotiations, to try to avoid outcomes where either producers or customers are very big winners or very big losers from fluctuations in demand.

Rio's efforts in achieving record levels of production in a year that started so badly also tends to reinforce the argument that the Pilbara joint venture, rather than allowing Rio and BHP more market power to force up prices, will result in more lower-cost production being pumped into the market. They would market their share of production independently.

The companies estimate synergies with a net present value of at least $US10 billion if the joint venture – which could be blocked by competition regulators in Europe and, perhaps, China – proceeds. The bottom-line impact of the expanded margins on Pilbara production they would market independently would be leveraged through higher volumes.