3. R AW MATERIALS AND INDUSTRIAL METALS
3.1 Iron ore market
3.1.1 Product and market characteristics: The key industrial commodity
Iron ore is a ‘pure’ intermediate commodity that in general cannot be recycled (except for some uses, e.g. coal washeries), though its main derived product (steel) can be re-used for similar or alternative uses without losing its original properties as a metal. Steel scrap is the only viable alternative material used for steel production. Additionally, as with other mining operations, the production of iron ore (extraction and the first refining process) cannot be converted to other raw materials. It is highly dependent on steel demand.
There are at least six categories of ores (hematite and magnetite are rare ores with the highest iron content of 70%, on average) from which iron ore can be commercially extracted (the iron content should be at least above 25%). Alternative uses of these fines are very limited. Iron ore is mined in two forms: lump, and fines. However, it can also be sold in pellets, which increase productivity in steel production because the fire in the furnace can escape through the air flows created by the material.
Production
After a long period (1968-2002) below 1,000 mega tonnes, world production of iron ore has more than doubled since then, as China entered the WTO in 2001 and implemented the removal of tariff restrictions by 1st January 2004. Production spiked in 2011 at over 2,000 mega tonnes (2 billion tonnes).
Figure 80. Iron ore world production (mega tonnes)
Source: Australian Bureau of Resources and Energy Economics (ABREE 2012).
Today, China is by far the biggest importer, and the second biggest producer, in the world (Figure 81). China is second only to Australia, which produces roughly 25% of global production, and ahead of Brazil (20% of global production).
Figure 81. Top four iron ore producing countries, 2004 and 2011
Source: Author’s elaboration from ABREE (2012).
Despite being one of the biggest producers on earth, China is still a net importer of iron ore due to its large manufacturing economy, as well as the low quality of its iron ore production (taking into account its low-quality ores, its real production should be halved to around 200 mega tonnes; see Figure 83). This makes the country a price-taker at the global level. In 2011, China held a 60% global share of imports in iron ore, with 65% of net imports as a percentage of world imports (IMF, 2011), despite its position as second largest producer, and its consumption has not eased much since the collapse of financial markets in 2008 and resulting spillover effects on the global economy.
Figure 82. Importers by countries and regions,
2011 (mn/t) Figure 83. Chinese Iron ore demand, 2000-2017F
Source: Author’s elaboration from ABREE (2012). Source: CRU.
International trade
International trade and the emergence of new economies based on heavy industries have played a key role in market structure developments in iron ore and the new pricing mechanisms. Before the early 2000s, the size of iron ore production and cross-border trade was a small fraction of its peak in 2011.
Figure 84. International trade ($mn)
Source: Author’s calculation from World Bank and Australian Bureau of Resources and Energy Economics (ABREE, 2012).
The size of exports vis-à-vis production levels grew to around 50% towards the end of the 1990s. Due to its supply concentration, the growth of iron ore as a seaborne market has also contributed to the growth of its cross-border trade.
0 Mt 200 Mt 400 Mt 600 Mt 800 Mt 1000 Mt 1200 Mt 1400 Mt
Import Production Consumption
Box 7. China’s entry in the World Trade Organisation
China’s entry in the WTO is perhaps the most important event for international trade in the last two decades. After a 15-year process, China was admitted to the WTO on 11th November 2001 after requesting to resume as contracting party of the General Agreement on Tariffs and Trade (GATT) in 1986 and requesting to enter the WTO in 1995, when the institution was established. Commitments to remove tariffs and other restrictions, already started before the accession, were mostly met by the end of 2004 when China became a fully-fledged global trade partner in the WTO. The opening up of its economy began back in 1979 (Rumbaugh and Blancher, 2004) and had since gathered pace. Entry in the WTO has led China to reconsider, among other commitments, the following (WTO, 2001):
Discriminatory practices between Chinese and non-Chinese WTO members.
Dual-pricing practices for domestic and export products.
Price controls to protect domestic firms.
Updates to current regulatory framework to reach international standards.
Full right to export and import in the country.
Export subsidies for agricultural product.
Despite some exemptions from these commitments (cereals, tobacco and minerals, among others), the deadline for the implementation of these commitments was three years from accession (December 2004). Since 2001, China has been easing many of these restrictions, even though there are several areas where further improvements are needed. Agricultural policies, renewable energy technologies, electronic payments and insurance regulation are some of the key areas (USCBC, 2010).
China has become the third largest global exporter and is very close to overtaking the United States (Table 39). Despite losing ground, the European Union remains well ahead of China as global trade partner, however.
Table 39. Top global exporters and China (% of total exports)
2001 2003 2011
European Union 40.1% 42.0% 35.1%
United States 13.1% 10.9% 9.6%
Japan 5.8% 5.6% 4.2% (4th)
China 3.9% (5th) 5.2% (4th) 9.5% (3rd) Source: Author’s elaboration from World Bank.
The gigantic growth of China is also clearly reflected in net imports. In particular, the explosion is visible for net imports in raw materials and metals, reaching around 14% and 30% of global imports, respectively.
Figure 85. Chinese net imports (% of world imports)
Source: IMF (2011, p. 4).
Active global trade accounts are also reflected in consumption levels, with China becoming the top global consumer of iron ore, aluminium, copper, and soybean oil in 2011. It is among the top three global consumers for crude oil (2nd), wheat (2nd), corn (2nd), sugar (3rd), and natural gas (4th). No major levels of consumption emerge for cocoa and coffee, but the Chinese weight is constantly growing over time in these markets too.
Table 40. China’s ranking in key commodities markets, 2001-2011/2012 Production 2001 2011/2012 2001 2011/2012 2001 2011/2012 2001 2011/2012 Crude oil 7th
*In 2003. a2012 estimate. Source: Author’s calculation from IMF Database, BP, OPEC, ICSG, USDA and other governmental authorities.
For agricultural commodities, such as wheat and corn, not much has changed in the last decade in terms of consumption levels, as the population is gradually stagnating and alternative use of biofuels production is still in early development. Overall, however, China has become the top global commodities consumer. It is unquestionable that China, over time, will need to make more efficient use of current resources as the energy-intensive nature of its manufacturing economy and its ageing population will put additional unstable pressure on commodities prices if the country does not increase its independence from external provision of low-cost resources. The more China increases in size, the more its weight on commodities markets may become unsustainable (at least in the short term) if competing global players do not reduce consumption levels. This situation might be seen as an incentive to finally increase efficiency in the use of global resources, but it will take years before relevant changes may see the light.
3.1.1.1 Supply characteristics: A Cournot equilibrium?
Due to its remote location from areas of consumption, most of the iron ore used for international trade is seaborne, accounting for roughly 50% of global iron ore production. Fines make up most of this (67%), while lump ores (15%) and pellets (11%) play a smaller role. Global proven reserves are estimated at 170,000 mega tonnes (USGS, 2012), which would last for roughly 80 years at the current production/consumption rate. However, iron can be found in several types of ores that are quite common on earth and which still need to be explored. Additionally, efficiency in the production of steel and its increasing substitution with other metals (e.g. aluminium) could potentially ease the pressure on increasing production. The substitutability of the product is limited to steel scrap on the demand side. Iron ore is mainly treated and used for steel production, and its final usability is limited.
Despite its direct use for steel, vertical integration with steel producers is very limited. Production
requires a huge amount of capital and stable flows to cover high fixed costs (mainly energy costs), on top of the limited storability of these ores. The storability period for this commodity varies among the different types of iron ore produced. In general, though, iron ore is limited since the commodity is bulky and its properties require costly storage facilities and huge capacity (which may reduce commercial viability). The flexibility of production to demand is limited, which does not attract steel producers. As storage of iron ore is costly and storability is limited, supply becomes more rigid and freight costs become a key item of the total price charged to end-users.
On the supply side, iron ore mining companies are typically large companies also involved in the extraction of other important minerals and raw materials (e.g. BHP Billiton and Rio Tinto). A few producers are vertically integrated with steel producers to exploit economies of scale, while others rely on long-term contracts (3-5 years). Integration with the steel industry has historically been limited due to national interests in keeping supply national and therefore fragmented, thus limiting economies of scale. Iron ore production is instead fairly integrated horizontally with other mining activities of raw materials (e.g. copper). Integration is a key feature of capital-intensive production with high fixed costs. Barriers to entry are high, mainly due to:
Exploration costs (for good quality iron ore).
Extraction costs (licenses, transport, infrastructure).
The need for ‘deep pockets’ (acquisition of local mining companies).
A complex pricing system (periodic negotiations about reference/benchmark price for the different ores and regions).
Despite initial investment constraints, iron ore capacity and the marginal cost of production are reasonably predictable in the short term. In addition, low demand elasticity (Chang, 1994; Hellmer, 1997), concentration in seaborne iron ore (the top three control roughly 65% of the global seaborne market; Figure 86), the homogenous nature of the product, and the system of long-term contracts (meaning one or a few regional prices prevail in international trade), ensure that the market organisation of supply follows an oligopolistic model à la Cournot (Cournot, 1838; Farrell and Shapiro, 1990; Hellmer, 1997; Warell and Lundmark, 2008). Each firm knows and assumes as ‘fixed’
(in that period) the quantity of output the other firms will produce, and acts accordingly. Therefore, firms end up setting the quantity as a reaction function of other firms’ production, which can be estimated through data on mine capacity. Brazil is deemed to exploit a first-mover advantage in the European market (Hellmer, 1997) and Australia may have the same role in the Asian market. The ability to move the market by setting quantities is certainly more relevant for top companies that control most of the seaborne iron ore market. However, transaction costs (e.g., the need of high production volumes) may lead to deviations from equilibrium, and may ultimately reduce incentives to collude.
The oligopolistic setting is often influenced by external factors, such as freight industry capacity and easier (cheaper) connectivity between regional areas. Freight costs are an important part of the seaborne iron ore price and can expose the market to unprecedented volatile patterns. For instance, freight costs (C3) in 2008 went down from 200% of FOB Brazil iron ore price to less than 10% in roughly six months (Figure 87). In other periods, it was more convenient to buy iron ore from Brazil and ship it to China instead of buying Chinese iron ore (Figure 88). However, recent changes with the increase in capacity of the freight industry have stabilised costs of freight for some time and ensure easy connectivity at the global level. This may increase the accessibility of new regional areas to the global market and reduce space for an oligopolistic setting as marginal costs become less predictable, so players can more easily defect to increase their profits. Small producers may even agree to non-profitable prices to win contracts, potentially creating a market imbalance that can move the market away from a Cournot equilibrium.
Figure 87. Freight cost (C3) as a % of FOB Brazil price
Source: ICAP.
Figure 88. Price differential China and Brazil ($/tonne)*
Source: ICAP. *Including C3 freight cost106 Globalisation also increases the likelihood that liquid spot prices may emerge and increase competition with other reference benchmark prices. These two factors can have a long-term impact on the supply setting. As a consequence, this static model would gradually become more dynamic (also on the basis of the lower profitability and stagnating demand) and induce big players to foster further industry consolidation to reduce the threat on seaborne trades of new regional markets. As today, production is geographically concentrated in a few countries, but things may change.
Finally, additional supply constraints are technological barriers to improving the production chain and making more efficient use of resources. Production also generates pollution, including CO2
emissions, while energy consumption requires access to cheap energy.
3.1.1.2 Demand characteristics: Rigidity versus pro-cyclicality
In line with supply characteristics, demand is also inelastic and, despite the large vertically integrated steel producers, steel manufacturers are price-takers and fragmented among regional areas. Demand is clearly inelastic at least in the short run, however. Over longer periods, prolonged downward cycles could put the industry at risk of oversupply if market conditions do not stabilise in the medium term.
For this reason, over the years the market has developed forms of long-term contracts to deal with supply and demand rigidity and to limit this instability. Contracts have been used to get credit from the banking system and develop production further. Emerging markets are also leading countries in the production process, and also through the constant growth of demand, which will drive future production and consumption (Figure 89).
106 C3 Freight cost is the benchmark cost of ship transport for bulk commodities from South America to Asia.
Figure 89. China and rest-of-the-world (ROW) iron ore consumption and seaborne demand
Source: BHP Billiton Iron Ore Growth and Outlook (2012).
Although the global economy has reduced its rate of growth, demand forecasts still remain solid, with seaborne iron ore demand growing at a faster pace as Chinese demand consolidates.
3.1.1.3 Key product and market characteristics
Key product and market characteristics of iron ore reflect a market for raw materials with:
High sunk costs.
Limited alternative uses and storability of the commodity.
Rigidity of supply.
Inelastic demand with limited cyclical patterns.
Moderate, but growing, industry concentration.
Emerging markets as important players on the supply and demand side.
Future consumption/production that is not going to slow down soon and that, together with the development of cross-border trade, has been driving significant changes to market structure.
Government intervention is mainly limited to countries where the government owns the mining companies (e.g. India) or to some countries where demand is far higher than production. Some restrictions to trade are applied in countries where demand is very high, such as China (10%) and India (10% on lump and 5% on fines). India may become a net importer now the Supreme Court has blocked mining activities that it claims are illegal. However, government intervention in other countries has also followed other directions. Most iron ore companies are private or have been privatised in the last two decades, so government interference is much lighter than in other raw materials markets. Additional government interventions are concentrated in supporting investments