In commodities, the cost curve dictates competitiveness.
Simandou might be a big resource, and the ferrous content of its ore – which is between 64 and 67 per cent compared with the two biggest Pilbara producers’ 60 to 62 per cent – makes it attractive in an emissions-reducing environment.
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It won’t, however, be a low-cost producer. Its “all-in” costs, because of the capital intensity of the infrastructure needed to get it to the port, are around $US55 to $US60 a tonne. It’s also about 14,000 kilometres further from China than the Pilbara, so shipping costs will be greater.
BHP, the industry’s low-cost producer, has all-in costs of just under $US20 a tonne. Rio’s are about $US25 a tonne and Fortescue’s about $US35 a tonne, although the quality of its ore, at about 56 per cent Fe, is lower than its main Pilbara rivals’ ore and attracts discounts.
That means, while it might be able to gain higher margins selling its ore to “green steel” producers, Simandou won’t be able to drive the ore coming from BHP, Rio or Fortescue out of the market, even if China would like to do so.
The Guinean government’s 15 per cent stake in Rio and Chinalco’s two of the project’s four blocks, and a similar interest in the infrastructure, is also an inhibitor to any attempts to drive prices down beyond the impact of the extra tonnes.
Unlike China, Guinea wants to maximise the prices received, not diminish them. It would prefer to see Simandou targeting green steel producers in Europe, rather than compete with the Pilbara producers in supplying China, although most of Simandou’s volumes will inevitably go to Chinese mills.
China this year lifted the pressure on Australia’s iron ore miners, with its iron ore bargaining group – China Minerals Resources Group – halting purchases of BHP’s Jimblebar blend in September.Credit: Bloomberg
While there will almost certainly be price impacts from introducing big volumes of new ore to the market, the positions of the Australian producers on the industry cost curve means that they can still generate big margins and profits, even if prices sink.
It is the marginal producers – the Chinese domestic producers and Indian miners whose costs are closer to $US80 a tonne – whose survival could be at risk from Simandou. BHP would still be generating gross margins of 60 per cent at those price levels.
The introduction of Simandou’s ore to the market, and China’s interests in the project, will, however, give China more leverage in price negotiations with the Australian miners.
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China has long sought to blunt the pricing power the miners gained in 2010 when BHP’s Marius Kloppers effectively forced the industry into adopting market-related pricing.
Before 2010, the industry norm saw Japanese and Chinese buyers (usually led by the Japanese) negotiating directly with each miner and then using the lowest price as the benchmark for all the West Australian miners.
This year, with steel production and therefore demand for iron ore softening, China’s iron ore bargaining group – China Minerals Resources Group – halted purchases of BHP’s Jimblebar blend in September and told mills and traders not to buy US-denominated cargoes at China’s ports in an attempt to gain lower prices and force BHP and the other Australian producers to trade in Chinese renminbi, not US dollars.
Last month, BHP is reported to have agreed to settle 30 per cent of its iron ore spot trading in RMB.
For China, that reduces exchange rate risks and transaction costs, possibly gives it another point of leverage in pricing negotiations and adds to its efforts to make its currency a viable alternative to the US dollar in commodity trades.
Throw the Simandou ore into the mix and the Pilbara miners are entering a new phase in the iron ore market’s development, one in which – in a market with more supply, where demand is weakening – they lose some negotiating leverage and China gains some.
Simandou may also factor in a different power play.
Before the 2008 financial crisis, Rio, concerned that BHP was stalking it for a takeover, made a massively over-priced, debt-funded acquisition of Alcan that undermined its financial stability.
BHP still made a bid, but China’s Chinalco seized the moment and bought 14.9 per cent of the shares in Rio’s London-listed entity (about 11 per cent of the dual-listed entity’s total issued capital).
The companies later announced a series of deals through which Chinalco would take up minority interests, whether directly or indirectly, and have representation at both the board and assets levels in most of Rio’s major businesses.
A BHP bid for Rio did eventuate, but it was later pulled as the extent of the financial crisis became clear.
A subsequent proposal to combine BHP’s Pilbara assets with Rio’s in a joint venture eventually torpedoed the Chinalco deals. While the joint venture never eventuated, its proposal had served BHP’s purpose of keeping Rio, and its WA iron ore assets in particular, out of China Inc’s clutches.
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The Chinalco shareholding in Rio, however, has remained and has been an obstacle to any Rio ambition to undertake capital management, or use its shares in an acquisition. Chinalco can’t increase its $20 billion holding (which would be the effect of a share buyback) without regulatory approvals it would be unlikely to gain, and doesn’t want to be diluted.
There have, however, been recent reports that with Rio now being led by a new chief executive, Simon Trott, the companies have been discussing a potential equity-for-assets swap, under which Rio would exchange direct interests in some assets for Chinalco’s shareholding and free up its balance sheet options.
It seems a reasonable assumption that Rio’s 42.5 per cent interest in its half of the Simandou project would be one of the earlier starting points for any serious discussions.
