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The Reflection on China’s Deficiency in Pricing Power in Iron Ore Negotiation GUO Yaowu, ZHOU Zhuang School of international economics and trade Tianjin polytechnic university, P.R.China, 300387 [email protected] Abstract: Although China is the world's largest importer of iron ore, it is hard to get the pricing power priority in the process of price negotiation between China and three major suppliers of iron ore. Based on the reasons of deficiency in pricing power and the analysis of the model of oligopoly, some measures are put forward in this paper, such as increasing industry concentration; improving the utilization ratio of scrap steel; implementing strategies of “going out” and import diversifying and so on. Keywords: iron ore negotiation, pricing power, industry concentration, monopoly 1. Introduction Iron ore is an important raw material for steel industry. The import demand for iron ore in China is on the rise for various reasons like too many lean ore with low grade that is difficult for exploiting and developing, and too high a demand for iron ore. As the world's largest importer of iron ore, China should have been in active status in the international negotiations. However, China lost pricing power priority repeatedly. What are the reasons in it? What measures should be taken by China's iron and steel enterprises to avoid the deficiency on pricing power? It’s a realistic problem which should be thought over carefully by academic group and real department. 2. The Summary of the Deficiency in Pricing Power in Iron Ore Negotiation Unlike the future price decided by the future contract in the international future market, the price of iron ore is determined by the major supply-side and demand-side’s commercial negotiation. The pricing mechanism was started in 1981.The negotiation begins in the fourth quarter of every year to decide the iron ore’s FOB price of the next fiscal year. The moment the agreement for iron ore price is reached by any mining and steel enterprise, the negotiation comes to an end. Other iron ore and steel enterprises are constrained by the price which is called long-term agreement price. The negotiators of the major demand-side of international iron ore negotiation are Shanghai Baosteel Group Corp, Japan's Nippon Steel, South Korea's Posco, Europe steel industry alliance while the negotiators of the supply-side are Brazil's CVRD, RioTinto and BHP Billiton. As shown in table 1, the iron ore price raised year after year when China joined the iron ore negotiation. China acquired pricing power priority in 2006 and 2007, the price increase by 9.5% for the iron ore is the best result reached between Shanghai Baosteel Group Corp and Brazil's CVRD. The status of negotiation changed markedly from 2008.The principle of “the same grade, the same increase” was broken and China’s pricing power was in a situation of lack. Japan's Nippon Steel and South Korea's Posco Rio firstly reached an agreement which included that the price of power ore and lump ore each increased by 65 percent and 71 percent. RioTinto and BHP Billiton refused to accept the price and demand the rise by 79.88 percent and 96.5 percent under the excuse of raising marine price. Baosteel was forced to agree this requirement. In 2009, the global steel enterprises were in a depressed state because of financial crisis and the iron ore’s supply exceeding its demand. In the global iron ore negotiation, Tinto took the lead with Japan's Nippon Steel to achieve 33 percent in power ore and 44 percent in lump ore annual price agreement, but China refused to follow. China steadfastly demanded the price cuts of 40 percent and reached a six months’ long-term agreement with FMG on Aug which showed that power ore and lump ore price drop by 35 percent and 50.42 percent respectively after lengthy negotiations. 573 With the recovery of global economy, Global crude steel production showed a restorative growth in the first quarter of 2010. The three major international mining giants offered a quarterly pricing system instead of the long-term agreement pricing mechanism, and forced a price rise by 80 percent to 100 percent. On April 13 in 2010, Nippon Steel and other Japanese steel enterprises reached a quarterly pricing agreement with Brazil's CVRD which showed that the FOB price is 105 U.S. dollars per ton 92% higher than that of the previous year. This meant that more than 29 years’ long-term agreement pricing mechanism was broken and China lost the pricing power once again in the negotiations. In the 2010 iron ore negotiations, China has proposed three principles such as the billing cycle by China's fiscal year, insisting on a long-term agreement, having a interaction between volume and price and a large quantity of excellent price, implementing the unified price not existing the Spot price and the price of a long association, and all the supplier signing an agreement with the steel enterprises in China must implement the unified price. But the three mining companies’ response was cool. This meant that China has not cast off the passive situation in iron ore negotiations. Fiscal year 2005 2006 2007 Table 1 The state of international iron ore price negotiations 2005-2009 Negotiating parties Chained increase % Agreed time Demand-side Supply-side Power ore Lump ore Feb 2005 Nippon Steel RioTinto 71.5 71.5 Baosteel BHP Billiton Jun 2006 19.0 19.0 () Baosteel CVRD CVRD Jun 2008 Nippon Steel and Posco Baosteel May 2009 Dec 2006 Feb 2008 2008 2009 Aug 2009 Data from: http://finance.ifeng.com 3. 9.5 9.5 65 71 RioTinto 79.88 96.5 Nippon Steel RioTinto –33.0 –44.0 Baosteel FMG –35.0 –50.42 The Reasons for the Deficiency in Pricing Power in Iron Ore Negotiation 3.1 China’s deficiency of iron ore, high demand and high import dependency China's iron ore reserves rank fifth in the world, 80 percent of which are lean ore. Lean ore not only has low grade (average grade is 33%) but also is of great difficulty to exploit. Meanwhile, with the rapid development of China's economy, all infrastructures have the huge demand to steel. At present, the domestic demand exceeds the supply and China has to import because of deficiency of iron ore and huge demand. The import of iron ore has increased form 92 million tons in 2001 to 628 million tons in 2009, an increase of 5.83 times and the average annual increase of 27.14%. Dependence on imports of iron ore has been improved from 45.89 percent in 2001 to 58.80% in 2009. China's over-dependence on imports of iron ore makes China in a passive position in iron ore negotiation. Table 2 year Dependence on imports Dependence on imports of iron ore 2001-1009 (%) 2001 2002 2003 2004 2005 2006 2007 2008 2009 45.89 49.00 53.14 55.39 56.70 52.58 52.00 52.24 58.80 Note: The data in the table is calculated according to China Statistical Yearbook 3.2 Low concentration of steel industry in China Industry concentration refers to the degree of control of the factors of production input and output by a few large enterprises. China's steel production ranks first in the world, while the industrial concentration of domestic iron and steel enterprises is very low. In 2007, the total production of China's four major iron and steel enterprises (Baosteel, Tangshan Iron and Stee, Anshan Iron and steel and Shagang Group) 574 was 94.41 million tons, accounting for only 19.3% of total production in China. The United States, Japan, Korea, the former four total production of iron and steel enterprises had accounted for more than 50% through joint reorganization. Even if Russia was in an economic transition stage, the former four of the proportion was as high as 76.72 percent. Those counties’ industry concentration mentioned above is much higher than China's. The low industrial concentration brought up some effects. First, bubbles were increasing in iron ore demand; second, the whole steel industry was disturbed by disorder development and malicious competition by small and medium enterprises. Since the dispersion of imports, it was difficult to form a unanimous idea and action and our bargaining power was severely limited. 3.3 The disorder market of import and domestic in China More than one hundred enterprises in China have the right to import and export the iron ore. There is a secondary market existing spot price and the price of a long association. Spot price has great influence on the long-term pricing negotiations. The increasing of spot price driven by spot demand will reduce the interest of the major suppliers and let our negotiation down. From January to September in 2009, the volume of Chinese ore imports soared to 123.2516 million tons while the actual needs was 66 million tons. The phenomenon indicated that iron ore is obvious oversupplied. Some enterprises imported the iron ore at the spot price blindly with disorder and bidding competition. Some imported the iron ore excessively with the view of hoarding, high resale and driving up the price of iron ore. This false demand made it possible for the supply-side to raise the price and greatly reduced our bargaining power. 3.4 The high monopoly of the international iron ore The volume of Australia, Brazil, India and South Africa's iron ore exports accounted for 85% of world iron ore trade. CVRD, Rio Tinto and BHP Billiton, the three mining enterprises controlled 70% of global iron ore supply. Being controlled by financial capital, they made monopolistic price based on the monopolizing position in the world market in order to pursue maximum benefits regardless of long-term interests and win-win principle. The high degree of monopoly of international iron ore led to the largest demand-side at a disadvantage. 4. The Analysis of Oligopolistic Market Model Based on the International Iron Ore Supply and Demand In today's international iron ore market, the major suppliers are CVRD, Rio Tinto and BHP Billiton. Compared to many buyers, the three giant enterprises have obvious advantages of a monopoly .It can be said that the international iron ore market is a element market of seller's monopoly. International iron ore production growth was moderate in recent years, while slow growth in iron ore prices was increased to different degrees over the same period. Thus, it can be assumed, the international iron ore supply curve, just as the supply curve in classical economics, is a positive slope curve S. It can be said that the marginal cost curve and the supply curve of iron ore factor (MC and S) is overlapped (see Figure 1). In recent years in the international iron ore market, the relationship between demand and price, the demand curve, like demand curve in classical economics, is a elastic curve of small negative. According to the law of supply, as factor supplies increase, factor prices would decline and vice versa in the element market of seller's monopoly; at the same time, the yield curve changes are more significant. Therefore, the marginal revenue curve of iron ore elements (MR) can be considered to be a steeper curve of negative slope located below the demand curve. Shown in Figure 1, if the international iron ore market is a fully competitive market, equilibrium occurs at the intersection E1of demand curve D and supply curve S .At this point, the quantity will be Q1, the price will be P1. In the iron ore negotiations, the three mining enterprises have developed a monopolistic union with one voice as the seller of elements. Under the circumstance of the increasing demand and the obvious conflict between supply and demand, they will fix the price at the intersection E2 of MC and MR curves in order to obtain high monopoly profits. At this point, the quantity will be Q2, the price will be P2. Therefore, the iron ore buyers including China only accept a considerable advance in price to 575 import iron ore at high price to make up for gaps in the domestic. P Price P2 S/MC P1 E1 E2 D MR Quantity Q2 Q1 Figure 1 Oligopoly pricing model in international iron ore market 5. The Measures for the Deficiency in Pricing Power in Iron Ore Negotiation for Iron Ore Steel Enterprises in China To sum up, fundamental changes won’t take place in the relationship between the supply and demand and the price of iron ore will be in the state of the seller’s monopoly. As the largest demand-side, China need to make long-term development plan and take the following measures in order to get the pricing power and then get out of the current embarrassing situation. 5.1 Increasing the concentration of iron and steel industry and forming a unified purchasing alliance The level of industry concentration to a certain extent will affect the industry's bargaining power. With low industry concentration, China needs to take some necessary measures if China wants to get equal bargaining power in the upstream and downstream industry chain. Chinese authorities should accelerate the merger and reorganization of the steel industry to raise industry concentration; adjust the industrial structure to achieve economies of scale and promote the adjustment of product structure and improve the added value of products to enhance the competitiveness of iron and steel enterprises. The major importers of iron ore in China are iron ore traders and iron and steel enterprises. There is a serious phenomenon of hoarding goods and “Daomaidaomai” and a disorder in iron ore import. From a strategic perspective, China needs to draw up industry laws and regulations, rectify the iron ore import market order, form a unified purchasing alliance, speak with one voice and then enhance bargaining power of the negotiation. 5.2 Grasping material life cycle theory and improving the utilization ratio of scrap steel In 1978, S.P.Magee and N.T.Robbins put forward a raw material life cycle theory. Raw materials life cycle is divided into three phases: the phase of derived demand growing, the phase of the substitution on demand and supply and the phase of artificial synthesis or research and development. Aiming at the steel market, in the phase of alternative of demand and supply relationship, scrap steel is 576 the only alternative for the iron ore raw material. As a result of limited iron ore resource and renewable scrap steel resources, China's steel enterprises should increase the recycling of resources and improve the utilization ratio of scrap steel. Then we can reduce the iron ore demand and dependence on imports of iron ore. 5.3 Encouraging the exploitation of domestic poor iron resources and implementing the "going out" strategy Increasing the proportion of domestic iron ore consumption is an essential approach to reduce the dependence on foreign iron ore and ease the supply and demand contradictions. On January 1 in 2009, the government adjusted the tax policy and imposed the fuel tax. The domestic mining had to face multiple burdens of value-added tax, resource tax and fuel tax .Thus the mining cost was much higher than the cost of imports. In view of this, the government should make an exemption of value-added taxes and expand its scope on mining enterprises in order to reduce the mining costs, increase national production and then reduce import demand. The large powerful iron and steel enterprises should invest in the upstream industry chain, for example, having investment on overseas mining resources and operating with shareholding. The government should also draw up industrial and public finance policies, such as implementing loans and financing policy on mining project, to help steel enterprises go abroad and then enhance the control over rights and interests over mine. 5.4 Implementing import diversifying strategy and controlling the international freight Considering the deficiency in pricing power in the iron ore negotiations, China's iron and steel enterprises should implement the import diversifying strategy and open up channels for iron ore import in order to avoid the risk of iron ore import. With the rapid growth of iron ore shipping capacity, corresponding bulk shipping market price have gone up. Meanwhile, ocean freight increased insanely under the manipulating of the international speculators (not ruling out three major mining enterprises). China's steel enterprises are at a disadvantage in the iron ore transportation business in general. Only a small number of large steel companies such as Baosteel Group signed an agreement with related maritime shipping companies. Most of them buy stock and rely on spot charters in short term and have no choice but to accept the rising made by shipping companies. Therefore, China's steel enterprises should establish professional transport companies or build up ships for iron ore with shipping companies in the long run to expand transport capacity and raise the proportion of self-control maritime force. The stability of basic fare can ensure the security of supply of iron ore and stabilize the costs of iron and steel production. 5.5 Focusing on the security of business information and perfecting privacy security regulations The security of commercial information is particularly important for iron ore negotiations. RioTinto spying case in 2009 is a classic case of revealing business information. When the commercial espionage seized state secrets in China and mastered all the information of China's steel enterprises including the bottom line price, China could not get the pricing power and plunged into a passive position. In view of this lesson, the iron and steel enterprises in China should strengthen the management of security work and perfect privacy security regulations in order to reduce the risk of theft and then get pricing power priority in the iron ore price negotiation. 6. Conclusion In oligopolistic state, the price elasticity of iron ore demand is low. Under the circumstance of the increasing demand and the obvious conflict between supply and demand, they will fix the price at the intersection in order to obtain high monopoly profits. The game between the seller and the buyer will continue in the coming years. Faced with this situation, we conducted a preliminary analysis and put forward some measures for China's steel enterprises in the iron ore price negotiations in order to get the pricing power. At last, I hope that this tudy can play a role in casting a brick to attract jade. 577 References ~ [1]. Gao Hongye.Western Economics.(3rd ed).Beijing:China Renmin University Press.2004:218 220(in Chinese) [2]. Zhao Chunming. International Trade.Beijing: Petroleum Industry Press.2002:62 64(in Chinese) [3]. Li Jianwu, Security Analysis and Policy Recommendations of Imports of Iron Ore.China's Mining Industry, 2008,17 (12) :26 29(in Chinese) ~ ~ 578