Rio crisis rooted in marketing strategy

July 10, 2009

— John Kemp is a Reuters columnist. The opinions expressed are his own —
   By John Kemp
   LONDON, July 10 (Reuters) – China’s detention of four Rio Tinto <RIO.AX><RIO.L> staff marks the final phase in the long downward spiral of relations with Rio and BHP Billiton,  <BHP.AX><BLT.L> Australia’s two major exporters of iron ore. While the arrests were unanticipated, the seeds of this crisis were planted long ago with changes in the miners’ strategy.  The end result will be to accelerate a shift towards using the spot market — rather than raw negotiating muscle — to set prices.
   Perhaps the most important transformation in the mining industry over the last ten years has been a generational shift at the top of the major companies. The mining engineers who traditionally dominated the top ranks have been replaced by MBA-trained financiers. The engineers’ traditional focus on output maximisation, process optimisation and cost reduction has been supplemented by a new emphasis on prices, profits and marketing.
   Mining firms have made major investments in market research and demand forecasting, as well as building up powerful marketing and negotiating teams. The overall objective is to plan and sequence new investment in capacity, as well as adjusting production from existing mines, to match supply with demand more or less continuously over the business cycle — avoiding the destabilising build up and run down of inventories that previously led to massive price swings.
   The miners’ ultimate goal is to reduce volatility and hold prices at a higher average level over the business cycle — maximising shareholder returns in an industry that was notorious for destroying value.
   The best way to think of Rio Tinto, BHP and some of the other majors is not as mining companies but as trading and marketing firms that have mining assets attached. The transformation has had two consequences:
   (1) As traders rather than miners, the firms have counterparties rather than customers. The producer-consumer relationship based on mutual advantage and creating shared value has been replaced by a trading mentality that sees deals as one-off transactions and conflicts over the allocation of value. All is fair in love, war and trading. Both the major Australian companies are perceived in the market as increasingly aggressive negotiators — breeding considerable resentment among customers, not least China’s steelmakers.
   (2) Both firms have invested heavily in market research and commercial information gathering to understand their customers’ requirements — and maximise the amount of value they can extract from negotiations.
   But the development of extensive market research and commercial information teams, allied to a tough negotiating approach, appears to have led to the current problems. There is a fine line between legitimate information gathering and more controversial activities — and the division varies between countries and over time. Disputes that are a matter of civil law in one jurisdiction may be treated as a criminal matter in another.
   China has a particularly expansive notion of what constitutes a state secret and a broadly defined espionage law. But it is not the only one. Switzerland and other OECD countries also have statutes criminalising economic espionage or breaches of confidence.
   At the same time as detaining the Rio staff, China has arrested Tan Yixin, the head of iron ore imports for state-owned steelmaker Shougang for “revealing China’s negotiating strategy” — in effect “China’s bottom line”. <For related news click [ID:nPEK191335]>.
   It is easy to see how the situation in China has become so tense — especially as relations between China’s steelmakers and parts of the Chinese government, on one side, and Australia and the major mining companies on the other, have become so strained. With so much ill-will around, even a misunderstanding can escalate rapidly.
   The detentions are simply the final phase in the downward spiral of relations. Conflict has been rising for five years as China’s expanding steel industry and booming demand for imported iron ore has handed all the negotiating leverage to Australia’s two major ore exporters and sent prices soaring.
   China responded to what it saw as the oligopolistic pricing power of the Big Three iron ore companies (BHP, Rio and Brazil’s Vale <VALE5.SA>) by organising its own coordinated buyers’ cartel under the auspices of the China Iron and Steel Association (CISA). The objective was to present a united front in the annual benchmark negotiations.
   But these efforts have been undermined by the activities of small speculative ore importers. As each year’s negotiations have dragged on, speculative imports have surged, driving up spot ore prices and strengthening the hand of Australia’s miners.
   Tensions first broke into the open in 2006, when China’s Ministry of Commerce sent a secret letter to the country’s customs inspectors asking them to scrutinise ore shipments for conformity with the bills of lading and import declarations — paying particular attention to shipments originating from Rio and BHP. In effect, the ministry was trying to restrict speculative imports in a bid to strengthen the steelmakers’ hands.
   When the letter leaked, it triggered a diplomatic incident. The Australian government issued a strong protest and threatened to make a formal complaint to the World Trade Organisation (WTO), accusing China of discriminating against Australian exporters. The issue was subsequently smoothed over as a misunderstanding.
   But simmering tensions burst out again when Chinalco’s [ALUMI.UL] recent attempt to increase its holding in Rio provoked a nationalist backlash in Australia in favour of an “all-Australian” tie up with BHP designed more or less explicitly to preserve the companies’ “pricing power”. While both sides have subsequently tried to downplay nationalist aspects of the deal’s collapse, it has added to the legacy of distrust and bitterness.
   Each year annual benchmark pricing negotiations have become more protracted. This year both the soft deadline of April 1 and the hard deadline of June 30 have passed without agreement. Rio has threatened to shift pricing to the spot market.
   In effect, Australia’s mining companies have suffered a complete breakdown in constructive relations with their most important customer. China still needs the ore, and the mining companies still need to sell it. But the benchmark system may have broken down irretrievably; it is hard to see how negotiations can continue in their present format when some of the negotiators have been arrested.
   The current crisis will probably accelerate the shift to a spot market pricing system. Spot prices could be presented as the outcome of “market forces” rather than raw negotiating muscle, drawing some of the political heat out of the issue.
   The crisis could also create a greater role for merchants and independent traders to act as intermediaries. BHP and Rio have spent years trying to squeeze merchants out of many of the markets in which they operate to build stronger direct relationships with end users. But the escalating conflict may force an about-turn.
For previous columns, Reuters customers can click on [KEMP/] —
(Editing by Martin Langfield )

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