The news that CVRD, Brazil's biggest iron ore producer, is discussing a 90 per cent rise in the price of the ore it supplies to European steel makers shows just why the share prices of some of the world's biggest miners have been surging.
Iron ore prices for the year beginning April 2005 are currently being negotiated between the major miners and the world's leading steel producers. Prices are set annually. Suppliers have consolidated in recent years and are now flexing their muscles.
"The iron ore producers have adopted an aggressive stance" says Paul McTaggart of Morgan Stanley equity research. He identifies two reasons for this: iron ore demand outpacing supply, and miners demanding a larger share of steelmakers' profit margins, which have risen strongly.
CVRD, Rio Tinto and BHP Billiton, all big iron ore producers, have seen their shares surge to near record levels.
Chinese steel production drives global demand growth. Morgan Stanley estimates global iron ore demand increased by a hefty 100m tonnes in 2004. Some 60 per cent of that growth was down to China, which produces a quarter of the world's steel.
This year's negotiations on prices for coking coal, the other main ingredient of the steelmaking process, have already concluded. Coking coal has been priced at around $125 a tonne, a whopping 116 per cent rise on 2004, according to Peter Blight at UBS investment research. Iron ore is following coke higher.
Mr MacTggart says miners are also concerned that returns on assets will fall as they build more capacity to meet demand. They need higher prices to justify the investment.
Parallels can be drawn with oil markets, where some analysts say higher crude prices are needed to provide adequate returns while the industry invests heavily to meet demand.
Jim Lennon, commodities analyst at Macquarie Research, identifies another factor propelling iron ore prices higher. He points to differentials in prices charged to Japanese customers that disadvantage Australian producers vis-a-vis Brazilian miners.
In Japan, Brazilian iron ore imports are subsidised to reduce the impact of higher shipping costs and prevent Japan becoming overreliant on cheaper Australian ore.
Australian ore has typically sold in Japan at $20-25 per tonne. Brazilian ore costs, on average, an extra $5 per tonne in shipping charges, but the Japanese absorb most of that to keep ex-freight iron ore prices for Australia and Brazil broadly in line.
In the last twelve months, however, the freight cost difference has widened to $18 a tonne. Japan's subsidies have kept pace as it has absorbed the extra costs, but this allowed a large gap to open between Brazilian and Australian iron ore import prices. In effect, Australia's Brazilian competitors are being shielded from the increase in freight rates.
Japan's preferred solution is to reduce the subsidy and make the Brazilians shoulder the extra burden. However, Mr Lennon says it is too late. "We are certain, now that the market is in chronic short supply, that the suggestion on the table is to raise the Australian price by more than the Brazilian price".
Current negotiations on Brazil-Rotterdam prices complicate the issue further. European talks conclude first and might form the basis for the final agreement in Asia. Mr Lennon's sensitivity analysis indicates that a 50 per cent increase in European rates could lead to a 114 per cent surge in Australian rates to Japan, implying a price of $81 per tonne. Unsurprisingly, profits for the main producers are rising. UBS expects pre-exceptional earnings before interest and tax in Rio Tinto's iron ore division to rise by 17 per cent in 2005, after being flat in 2004.
Steelmakers, however, are unlikely to see their margins eroded too much given the doubling of steel prices in the last two years. Mr Lennon says: "Given that average steel prices are at least $300 per tonne higher, this is a rise that can be afforded."
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