London, 4 April 2010

Tensions between the big three iron ore miners and steelmakers finally boiled over last week. Eurofer, the steelmakers' association, wrote to the European Commission to complain about "possible anti-competitive practices and abuse of dominant position by the main iron ore suppliers", possibly breaching articles 101 and 102 of the European Treaty.

The abrupt shift to quarterly contracts linked to spot prices, coupled with increases of as much as 80-100 percent, has pushed into the open what everyone has known for some time: The dispute between the miners and their customers is not about arcane pricing systems. It centres on the fundamental structure of the industry. The question is whether the market can be considered competitive when supply is dominated by three major players and there are formidable barriers to entry.

Miners claim the threat of entry will keep them honest. Steelmakers argue barriers facing entrants are too large to restrain the pricing power effectively and complain bitterly about what they see as unacceptable coordination.

"Eurofer has already indicated to the European Commission its concern at the very high level of concentration on the seabourne iron ore market which is dominated by just 3 producers (BHP Billiton, Rio Tinto and Vale) and the unacceptability therefore of the proposed joint venture between BHPB and Rio Tinto", according to the association.

While the complaints are not new, this is the first time the steelmakers have openly accused the big three of "strong indications of illicit coordination of prices increases and pricing models and pressure on individual steel producers to accept these changes" potentially breaching EU rules.

In contrast, the miners argue new contracts better reflect real supply and demand conditions at a time of rising steel production, especially in China.

Confluence of Events

Escalating tensions come at a particularly sensitive time because BHP and Rio are still waiting to receive clearance for their proposed production joint venture (JV) for mining assets in Western Australia.

European regulators, and their counterparts in Australia and the rest of the world, now have no choice but to decide whether the industry is competitive, or if there is sufficient cause for concern to justify heightened scrutiny, a sectorwide investigation, or tough behavioural restrictions.

The awesome pricing power displayed by the big three in ending the system of annual contracts and pushing through massive price increases in the early stages of an economic recovery, just a year after they successfully minimised price cuts during the deepest recession since World War Two, will only heighten suspicions about the JV's effect on competition and prices paid by customers.

ACCC First Review Clears Miners

The Australian Competition and Consumer Commission (ACCC) has been making enquiries since December as part of an informal review into the JV's impact on Australia's steel industry.

ACCC controversially cleared the last proposed link up between BHP and Rio Tinto in October 2008, when it gave BHP the go-ahead to buy Rio outright. The deal unravelled when the European Commission indicated it would demand asset disposals and BHP decided it could not command a sufficiently high price in the very depressed market conditions following the collapse of Lehman Brothers in autumn 2008.

At the time, ACCC published a detailed statement of issues setting out possible concerns about the deal, including barriers to entry, the potential for the three major firms to exercise price leadership, or withhold capacity from the market and sequence expansions to keep prices artificially high.

Just over a month later ACCC cleared the deal, after further consultations, noting that "while significant concerns were raised by interested parties in Australia and overseas, the ACCC found that the proposed acquisition would not be likely to substantially lessen competition". While statements of issues are, by their nature, preliminary and somewhat speculative, it was never made clear why ACCC became more comfortable with the deal. Now ACCC is citing changed circumstances for another probe.

Bluescope Steel

Its new statement of issues, published on March 25, provides a much better insight into the Commission's thinking: "The ACCC's primary focus in the 2008 review was whether the proposed merger was likely to result in a substantial lessening of competition in a market in Australia ... ACCC considered among other things BlueScope Steel's position as the only significant customer of iron ore in Australia."

But while the ACCC was finalising its review, "BlueScope Steel entered into a 10 year contract with BHPB for the supply of iron ore lump and iron ore fines. It noted, in its press release in September 2008, that the contract was expected to "maintain BlueScope Steel's competitive position in the industry". It did not indicate any concerns to the ACCC about the proposed acquisition".

BlueScope now seems to have had a change of heart. In an interview with The Australian newspaper, Chief Executive Paul O'Malley complained there was a "definite asymmetry" between miners and steelmakers in terms of what they know about market conditions because the same small group of miners is involved in negotiations on almost every deal.

"I am very concerned about anything that increases rather than decreases concentration, and also increases barriers to entry from others that would give a bit more diversification of ownership". He went on to say "Rio and BHP have been quite open about the benefits of the joint venture. Whether that actually flows on to the steel industry or not, I'm not sure".

ACCC has cited BlueScope's newfound concerns as one reason to take another look at the nature of the industry and the JV's impact. It now has a domestic Australian reason to exercise its competition powers rather than nebulous concerns about a link to international markets and the impact on foreign as well as domestic steelmakers.

Flexing Output and Projects

ACCC has also expressed interest in the industry's response to the downturn. ACCC notes that "the competitive constraints identified in 2008 ... have not come online as anticipated".

"Existing suppliers have delayed, cancelled or reduced their capacity expansion plans, and some potential suppliers have delayed, cancelled or reduced their entry plans". Both Rio and Vale cut production substantially. While these decisions may well have reflected the global financial crisis, ACCC worries "they might also reflect strategic behaviour with the purpose of limiting the decline in iron ore prices".

"If ACCC were to find evidence that the ... production cuts were made ... for the purposes of limiting the decline in prices" it would indicate "there are opportunities for the large, low cost iron ore producers to withhold supply" and "the responses of competitors do not effectively constrain this conduct".

To allay concerns, BHP and Rio have structured their new deal as a production-only JV, and dropped earlier proposals to jointly market a small portion of the output. It may not be enough. Respondents to ACCC's market enquiry told the regulator "separate marketing functions would not ensure that effective competition on any level remained between BHPB and Rio Tinto post-JV".

Consultation Reveals Hostility

In a barrage of complaints, the market enquiries revealed concerns from some market participants the JV would increase the ability and incentive of the companies to pursue a withholding strategy (paragraph 43); make them more likely to tacitly collude with Vale (44); and under the new index pricing system give it more power to manipulate the supply demand balance (45). That said, ACCC has seen information some ore projects are proceeding as intended and Chinese steel mills, in particular, are taking steps to finance and encourage new sources of supply.

Most market enquiries are fairly anodyne. The unusual frankness and bluntness of these concerns is testament to how far relationships between the miners and their customers have broken down and become mired in distrust and endless conflict.

While a sector-wide review does not seem to be contemplated at the moment, the need to decide on the proposed JV means competition regulators cannot avoid taking a view on whether the industry's structure is competitive or not.

Ends --

By John Kemp, Reuters market analyst

The views expressed are his own