Financial Regulatory Forum

COLUMN – Iron ore concentration raises valid concerns: John Kemp

By Reuters Staff
April 7, 2010

By John Kemp

LONDON, April 7 (Reuters) – In a new twist to the iron ore saga, Brazil’s giant iron ore producer Vale has launched a blistering counter-attack on European steelmakers, accusing them of coordinating their approach to ore negotiations in a manner that would raise issues under European competition law.

The accusations are contained in a letter to the European Commission, details of which have been released on the company’s website.

Vale strongly rejects allegations from the steelmakers it has broken European law in discussions about future supply agreements by exchanging information or pricing strategies with any competitor. All major producers insist the market is ferociously competitive.

SUCKED INTO SOMEONE ELSE’S WAR

Vale has been drawn into the spiralling dispute between the steelmakers and BHP Billiton and Rio Tinto over their proposed joint venture in Western Australia as well as the abrupt change from annual to quarterly contracts referenced to the spot market.

Steelmakers are furious about the near-doubling of ore prices this year as well as the switch in contract terms.

It has become common to accuse the big three of wielding “pricing power” (a euphemism for monopoly) in the market for seaborne iron ore where they control about 70 percent of global supplies.

But Eurofer, the EU steelmakers’ association, went further last week, directly accusing the iron ore firms of possible “anti-competitive” practices. Its letter cited possible breaches of Article 101 (which prohibits restrictive practices) and Article 102 (which prohibits abuse of a dominant position) of the European Treaty.

The Australian Competition and Consumer Commission (ACCC) is considering whether “post-JV, the JV entity and Vale are more likely to tacitly collude by coordinating their decisions relating to price, volume and/or quantity”, according to the statement of issues published last month (paragraph 44).

“The ACCC is also considering whether there is increased potential for the proposed JV and Vale to coordinate their decisions on product volume or quality” (paragraph 52).

ACCC has extended the deadline for announcing a decision on the joint venture to seek more information from affected parties about the concerns raised.

SIGNS OF DYSFUNCTIONAL INDUSTRY

Business relationships are often wrapped in fuzzy phrases about creating value for customers and win-win situations. The reality is transactions are about allocating value, gains for producers often come at the expense of consumers and vice versa.

Only if the prospect or reality of a (temporary) monopoly stimulates investment and innovation, leading to increased opportunities for both sides in the long term, is a transaction truly positive-sum — the theory of “creative destruction” associated with Austrian economist Joseph Schumpeter.

Markets create winners and losers, and commodity businesses are often characterised by a high degree of aggressiveness. Even so the level of bitterness and aggression in iron ore has reached an extraordinary level.

It is difficult to think of another industry where producers and consumers have simultaneously filed competition complaints against one another, in an epic antitrust battle spanning regulators in Europe, Asia and Australia, that might yet spread to bring in the big guns at the U.S. Department of Justice.

Not to mention the four former Rio executives now serving prison terms in China on bribery and commercial secrets charges (indirectly) arising from the iron ore negotiations.

The bitterness of this fight cannot be called normal. It reflects a breakdown of constructive relationships between the ore producers and their customers.

Some will argue the tension reflects personalities and the internal culture of the major miners. It also reflects renewed tightness in the market resulting from China’s voracious demand for steel. It will not be cured for years, given the long lead times for investment (estimated at 10-15 years to bring on a greenfield mine, according to ACCC).

But perhaps it was inevitable given the lopsided nature of the market, with three massive producers facing a fragmented steel industry in which no steelmaker holds more than about 10 percent share, and most are far below this level.

POTENTIAL COMPETITION A CHIMERA

Competition lawyers and their allied army of econometric consultants have spent much of the last 30 years eviscerating competition law.

Pro-merger lawyers have successfully argued even a large share of the relevant market should not necessarily draw suspicion because pricing power can often be restrained by the threat of entry by “potential” new competitors or even whole new technologies waiting in the wings to pounce in the event a dominant position is abused or monopoly profits earned.

The repudiation of a century of antitrust law reached its apogee with a remarkable U.S. Supreme Court decision in 2007 (“Leegin Creative Leather Products”) overturning a 1911 precedent.

In this case, about pricing agreements rather than market share, a closely divided court found agreements for enforcing minimum retail prices were not automatically illegal and against consumer interests but should be judged on a case-by-case basis, weakening a key protection for customers.

In a counterintuitive finding the court wrote: “Economics literature is replete with procompetitive justifications for a manufacturer’s use of resale price maintenance … [It] can stimulate interbrand competition between manufacturers selling different brands of the same type by reducing intrabrand competition among retailers selling the same brand”, according to the informal summary of the judgement (syllabus, page 2).

The emphasis on econometric studies and competitive discipline posed by “potential” entrants in future is not much comfort to steelmakers negotiating today with only three “actual” suppliers. Given long lead times, and enormous barriers to entry, potential-entry discipline seems rather ephemeral.

A market with only three major suppliers cannot really be termed “competitive” unless it is very easy for others to enter in a short time frame with moderate investment. Iron ore clearly does not meet those criteria.

MINERS SCORE AN OWN GOAL

Doubts about the level of competition in the market have heightened following the miners’ successful demand for massive price increases in recent months and the switch in contract terms, displaying just how much power they have in this market.

Rio and BHP have shot themselves in the foot. Price increases and contract changes now have poisoned the environment for a production joint venture they hope will benefit them in the long run. Vale has in turn been drawn into a dispute not of its own making as the primary means of keeping competitive pressure on the other two.

If potential entry could not restrain huge price increases in 2010, can regulators rely on it to constrain further big rises in 2011, 2012 or even 2015? Recent events must give reason to pause. ACCC is certainly having second thoughts, after it previously authorised a full Rio/BHP combination back in 2008.

The fundamental point remains. No market with only three significant suppliers and substantial entry barriers can really be considered competitive. Econometric competition is not the same as the real thing. It cannot provide the same level of visible competition and choice among alternative suppliers to ensure prices are set, and importantly seen to be set, in a competitive market place.

Breaking up the big three is a step too far for EU regulators. Most operations are located in Brazil and Australia; an EU attempt to restructure the industry unilaterally would invite accusations of neo-colonialism (Brazil’s mining lobby has already raised the point). It would be easier if ACCC took the lead in imposing tough behavioural restrictions and other conditions.

But at a minimum the whole industry should be subject to a sector-wide study and intense scrutiny by the EU and other regulators, to provide the protection consumers cannot rely upon from competition. (Editing by Sue Thomas)

((john.kemp@thomsonreuters.com; reuters messaging: john.kemp.reuters.com@reuters.net; +44 207 542 9726))

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