By All Means Necessary (7 page)

Growing Chinese demand for resources is not just influencing prices; it is also affecting how underlying markets work. A lot of ink has been spilled on worries that China is “locking up” resource supplies, eroding the role of global markets in governing resource trade. The real impact on global markets, however, is different, more varied, and often more broadly beneficial than this caricature suggests.

Among the three biggest mineral markets—for copper, bauxite, and iron ore—only the copper market comes close to resembling the flexible and transparent market for oil. From the end of World War II through mid-1978, the copper market was characterized by a mix of long-term contracts and spot market sales.
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Contract sales were based on a “producer price, ” which reflected supply costs plus a premium, while spot sales were based on prices determined through the London Metals Exchange (LME); large differences between the two prices could persist. In the late 1970s, following the nationalization of copper production in Chile, Peru, Zaire, and Zambia (the
four top copper exporters), long-term contracts were broadly broken, and producers shifted to selling on a spot basis through the LME. Today, copper is sold through a mix of spot and long-term contracts, but the latter differ from their past structures: instead of setting prices on the basis of producers' costs, they typically price according to New York or London exchange prices, essentially in the same way that markets work with oil.

The iron ore market has long been different from both those of copper and oil. The emergence of China, though, has changed things radically. The story of how this happened sheds light on the surprising ways in which China can influence the structure of global markets.

Much of the world's iron ore has historically been produced in “captive” mines owned by steel producers and priced at levels designed for internal corporate convenience rather than to reflect its market value. Since steel making requires large up-front capital investments, securing a stable supply of the material (in order to make sure steel plants are put to full use) has been more important to many companies than realizing the lowest possible price. Most other trade between merchant iron ore producers (those that do not own their own steel plants) and steel makers without captive mines was conducted on long-term contracts with prices set through specially structured annual auctions.

Here's how those worked. Three companies, Vale, Rio Tinto, and BHP Billiton, together control more than 70 percent of seaborne iron ore trade.
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A handful of large companies—primarily from Japan, South Korea, and Taiwan—similarly dominated the demand side of the picture until recently. Early every year, the largest iron ore producer would enter price negotiations with the largest consumer. Once they came to an agreement, their price would be used for all companies' iron ore deals for the year. Spot trade has long been tiny in comparison.

Beginning in the early 2000s, Chinese steel makers assumed an ever greater role in global iron ore markets. Until 2005, though, Japan-based Nippon Steel still dominated negotiations on the side of the steel makers, but beginning that year the Chinese firm Baosteel took the lead in annual negotiations, as China moved to become
the biggest steel-producing country in the world.
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Baosteel was followed in 2006 by a consortium, now organized by the Chinese government but still represented by Baosteel, which aimed to gain more power in price negotiations. In principle, this shifted China into a stronger role in the iron ore market.

At the same time, though, a host of smaller Chinese steel makers chose to procure their iron ore through spot market sales.
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The domestic industry was highly fragmented—far more so than the steel industries in other major steel making countries. (China had three thousand companies, Japan had five, and Taiwan and South Korea each had one.)
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This contributed to growth in spot markets. By 2005, nearly half of Chinese iron ore imports were made through spot markets.
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As this trend emerged, the Chinese government did not embrace it. Instead, over the next several years, the government focused on reducing competition among iron ore importers, hoping to reduce prices as a result. Between 2006 and 2009, it repeatedly took steps to limit the number of companies able to import iron ore, restricting licenses, raising capital requirements, and limiting each company's allowed imports.
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Meanwhile, though the big Chinese steel companies continued to use long-term contracts, they competed among themselves, reducing their market power. In 2006, Baosteel, attempting to represent the broader Chinese industry, failed to come to timely agreement with the major iron ore producers. Producers thus shifted to talks with the major Japanese, Korean, and European buyers. Chinese contract buyers were ultimately forced to accept the price agreed to in those talks—substantially higher than what they sought.
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The big shift came in 2009. Chinese buyers failed for months to come to agreement with the major iron ore suppliers. Korean, Japanese, and Taiwanese steel makers all ultimately agreed with the big three producers to prices (the same for all three) for their 2009–10 contracts. But the big Chinese firms, with their growing collective market power, continued to demand a lower price. On July 4, amid this conflict, China arrested four Shanghai-based Rio Tinto executives, accusing them of stealing secret Chinese information of value
to the iron ore negotiations.
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China's state-run news service
Xinhua
reported that a “new Chinese report said Rio's spying meant Chinese steel makers paid more than 700 billion yuan ($102.46 billion) more for imported iron ore than they otherwise would have.”
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China eventually walked back some of its accusations, but tensions remained.
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The iron ore price negotiations were ultimately inconclusive. Both the iron ore producers and the big Chinese buyers—the latter eager to take advantage of falling spot market prices spurred by the global financial crisis—turned to spot market trade, which had already grown on the back of demand from small Chinese mills. The spot market ultimately accounted for 60 percent of global iron ore trade in 2009.
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From there, the entire iron ore trade moved strongly toward shorter-term pricing. Long-term contracts with non-Chinese buyers began to shift away from the old, pitched annual negotiations over prices, ending the forty-year-old approach to iron ore trade. Instead, prices were increasingly determined by reference to spot markets.
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“This is a momentous occasion, ” one analyst told the
Financial Times
. “The industry is revolutionizing the way iron ore is priced.”
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The period in some ways resembles what happened in the 1970s and 1980s as the world oil market underwent a similarly radical transformation.

The ensuing years have brought growing conflict over the new system.
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Within China, smaller steel mills, previously disadvantaged relative to their larger competitors, have welcomed the change; larger producers, now with even greater potential market power, have regularly suggested that a return to annual contract talks would make sense.
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Similar sentiments have come from outside China; Posco, the Korean leader, has called for a return to annual contract prices, without success thus far.
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Meanwhile volatile prices have increased the appeal to Chinese buyers of owning their own supplies; this sort of vertical integration, common in North America, is the most obvious way to hedge against iron ore price volatility absent deep financial markets. Together with the broader government interest in owning overseas resource deposits, this helps explain growing Chinese efforts to take equity stakes in overseas iron ore mines.

The broader story of iron ore carries an important lesson: the emergence of China has changed the system radically—but not at all in the way Chinese policy makers or industry wanted. (Something similar has happened with bauxite markets, which have become more flexible in recent years, following iron ore's lead.)
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Large Chinese steel makers, aided by the government in attempting to negotiate collectively, hoped to use the old structure of price negotiations to exercise market power and get lower prices. But a combination of two other Chinese-driven factors—the emergence of large numbers of smaller producers, and a volatile price environment that complicated negotiations—ultimately helped push the system in precisely the opposite direction.

Unlike oil and copper, which have long been traded in deep and flexible markets, and unlike iron ore and bauxite, which are moving that way, natural gas remains traded in relatively inflexible and opaque markets, making the natural gas trade more vulnerable to political machinations. The biggest future prospect for Chinese influence may be the possibility of changing this situation and helping usher in a more transparent market-based approach to trading Asian natural gas.

In North America, natural gas is priced transparently and openly, both through exchange-traded contracts and extensive physical trade. The continent is well integrated through a dense network of pipelines, making it relatively straightforward to translate prices from one place to another. Asia, though, is strikingly different. The main Asian consumers of natural gas are Japan, China, Thailand, South Korea, India, Malaysia, Indonesia, and Pakistan. These markets are balkanized. Japan and Indonesia are islands; South Korea is effectively an island too, cut off from other markets by oceans and by North Korea. India and Pakistan have warred with each other and proven unable to build pipelines across their border; and the border between China and India, meanwhile, is too rugged and mountainous to accommodate an effective pipeline system. This all thwarts efforts to create
a single transparently determined price for Asian natural gas, since there is no reason natural gas should sell for the same price in, say, both Japan and India. Instead, Asian natural gas buyers typically enter long-term contracts with sellers in which the price they pay for natural gas is set by a formula that itself is based on the price of oil.

Moving to a more open and transparent system would take a willful act by a powerful consumer to create a trading hub. That consumer would need to put in place the physical and institutional infrastructure (pipelines, storage equipment, transparent and reliable contracts, and so on) that allows prices to be determined through open markets. It would need to require foreign suppliers, which typically prefer the lucrative “oil-linked” contracts that are still the norm, to use it—and the market in question would also need to be important enough that those suppliers couldn't say no.

China might seem a prime candidate to play this role, thanks to its large and growing market for natural gas and the potential to secure lower natural gas prices through a market-based trading system. But to do this, the Chinese government would need to develop a physical hub where natural gas prices could be determined, and a pipeline network that connected the hub to much larger markets within the country. It would also need to liberalize its own internal natural gas market, so prices could be transparently determined; it might also need to open its financial markets enough to allow the creation of derivative financial products so traders could hedge against price changes. And it would need to invest enough in gas-using infrastructure (probably power plants) to make its import market too big for suppliers to ignore.

In early 2013, a team at the International Energy Agency assessed the potential of several Asian countries to become liquefied natural gas (LNG) trading hubs. It found that China failed to meet several requirements the team deemed necessary: deregulated gas prices, sufficient pipeline capacity, competitive markets (three companies dominate LNG trading in China), and relatively free access to capital markets, which would enable the participation of international financial institutions in trading and in creating derivative contracts.
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Most fundamentally, then, Chinese leaders would need to decide they were ready for significant economic changes before they could effectively create a natural gas trading hub. If Chinese leaders prefer to keep pricing opaque and to use their leverage as a big consumer to negotiate low prices, then they will not take the steps needed to transform the Asian LNG market. One way or the other, though, China's rise as a consumer means it will play a larger role in determining how commerce in natural gas, especially in Asia, develops.

What about the structure of global markets for raw agricultural materials? In many ways, these are even more politically distorted than markets in energy and minerals. Large numbers of developing countries strictly control food prices, which are near-universally matters of political sensitivity, particularly where they make up a large part of household budgets. Many more countries—developed and developing—subsidize food production. Food markets are, moreover, particularly prone to interference with trade. Food-exporting countries have frequently erected export bans or quotas in the face of global price spikes in order to lower domestic prices. It is not entirely unreasonable, in this context, for China to desire some control over its food supply.

It is not clear, though, that the emergence of China will change very much the way food markets work. To the extent that the country pursues domestic self-sufficiency while retaining some controls on prices, its activities will largely be isolated from global markets. Chinese overseas food production, meanwhile, is unlikely to be exempted from emergency export restrictions imposed by food-producing countries. Limits to Chinese acquisition of land will also be constrained by other countries' own concerns (whether or not well founded) over food security and their unwillingness, therefore, to let large tracts of land fall into the hands of other countries. It is far too early to conclude from this that the quest for productive overseas land will fundamentally change the distribution of food
production worldwide, particularly as the Chinese role in world food markets remains limited.