September 19th 2009

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Articles from this issue:

COVER STORY: 'Level playing-field' crushes Australian farmers

MARRIAGE AND FAMILY: Back to basics in the marriage debate

CANBERRA OBSERVED: Assessing Rudd's stimulus package

NATIONAL AFFAIRS: Rio Tinto, China and Australia's national interest

EDITORIAL: California wildfires caused by lack of hazard reduction

WATER: Water policy threatens Australia's food security

ILLICIT DRUGS: Kings Cross safe injecting rooms fail to reduce drug overdose deaths

QUEENSLAND: Bligh Government amends abortion laws

GLOBAL FINANCIAL CRISIS: Ireland follows Iceland in financial meltdown

FOREIGN AFFAIRS: Japan's new PM rejects 'market fundamentalism'

CULTURE AND CIVILISATION: The debasement of higher education

EDUCATION: Seeking a better deal for rural and regional students

OPINION: 1945 Allied repatriations a crime against humanity

NCC Fighting Fund appeal (letter)

Senator Ted Kennedy (letter)

Abortions are never justified (letter)

World War II (letter)

CINEMA: Revealing insight into Rebiya Kadeer - The 10 Conditions of Love


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Rio Tinto, China and Australia's national interest

by Colin Teese

News Weekly, September 19, 2009
China appears to be taking a more robust attitude to its relationships with trading partners - especially Australia. It attempted to take a significant stake in the coal/iron ore producer Rio Tinto, and for a time the management of Rio seemed interested.

Of course, the Chinese acquisition could not have gone ahead without the approval of the Australian Government.

There was no shortage of gratuitous advice to the government. Dedicated free market enthusiasts, predictably, insisted that foreign investment was a necessary and desirable acquisition, whatever the source.

More considered opinion regards this view as too facile. As to how the government would have come out, we don't know. But we do know that the undiluted free market view is heavily represented within Kevin Rudd's Cabinet. Its views might well have prevailed.

At a different level, it seems that Rio's attitude to managing its relationship with its biggest and most valuable customer is a work in progress. For the moment the company appears to prefer maximising whatever short-term advantage it can create in its price negotiations.

For many years - and going back to the time when our biggest customer was not China, but Japan - pricing for these sales was on the basis of negotiated term contracts. There has always been some controversy associated with this arrangement, going back to Gough Whitlam's time and his notorious minerals minister Rex Connor.

Minister Connor certainly believed that our companies, by competing with each other for volume over price, were playing into the hands of the combined buying strength of their then most valuable customers, the Japanese steel mills.

If that ever was true, those days are long gone. Chinese buyers are as skilled and coordinated as the Japanese ever were, but the negotiating arrangements from our end are much more sophisticated.

Sellers still rely on volume sales and term contracts (usually three years) - for good reasons. Large-scale mining development requires huge borrowing for investment in new capacity.

Banks go after this lucrative business cautiously: they want to see evidence of firm purchasing commitments from the buying end to ensure their investment is reasonably protected.

As it turned out, term contracts were quickly demonstrated to be of limited value in protecting banks. When, in the 1970s, the world steel market turned down sharply, Japanese buyers were unable to take up the contracted volumes of iron ore and coal.

In such a market downturn it made no sense to try to enforce contractual obligations. Since then, buying contracts have had less appeal to miners. However, banks lending large sums still want some evidence of long-term commitment from buyers.

Rio (and possibly BHP) is attracted to the idea of selling at the spot price rather than negotiating a fixed price. Under such an arrangement, customers would pay what is, in effect, the day-to-day market price for its iron ore and coal at the time of purchase.

Presumably, the companies have looked at the drawbacks of this approach; spot prices will be influenced by many factors - not merely the ebb and flow of demand and the state of the world economy.

Oil, a commodity traditionally traded on the basis of spot prices, beautifully illustrates the point. Oil marketing is, above all, subject to the influence of a de facto cartel. The Organisation of the Petroleum Exporting Countries (OPEC) - to which most big oil-producers belong - exerts a major distorting influence on spot prices. Indeed, OPEC exists for the very purpose of containing price competition. Its aim is to control supplies to the market so as to allow producers to extract the best possible spot price from customers.

From the beginning, believing that its commodity was in limited supply, OPEC members wanted to sell less oil for a higher price.

However, cartels don't always work as intended. We all can recall what happened to the spot price for oil a year or so back. For largely unexplained reasons, spot prices for oil went to astronomical levels and seriously threatened world economic order.

It is quite likely they could have spiralled hopelessly out of control without any action by Saudi Arabia, the world's biggest producer and founding member of OPEC. OPEC could, and did, with a commendable sense of responsibility step up production - in the interests of producers, consumers and world economic stability - and thus helped contain some of the upward price movement.

From the outside, all of this seems like a pretty untidy arrangement to manage oil pricing and distribution. But it seems to work. Does this mean it would do the same for iron ore and coal? Not necessarily.

Iron ore and coal are not oil. Every country on earth wants oil and their economies are seriously affected for good or ill by what happens to the price and supply of oil. But the sources of supply of oil are limited and reserves are seen by many to be imminently finite. In these circumstances, producers are more interested in price than volume. That is what suits the nature of their commodity.

The market for iron ore and coal is driven by different imperatives. The big purchasers of the commodities seem to be geographically concentrated, few in number and well organised to negotiate on price. As for iron ore and coal exporters, given the nature of their mining operations, they must chase volume; they will always be more vulnerable on price.

There is also the question of freight costs. Markets have for many years been concentrated in Asia (Japan and then China). Suppliers have been Brazil and Australia. Australia has a huge price advantage on freight over its Brazilian competition. Landed cost, in China, for the Brazilian product must be higher.

Australian sellers have said this was unfair: they should not lose in overall price because their landed costs were lower. The advantage accruing to China from lower costs should be shared with Australian producers. In the push and pull of negotiation it appears our negotiators have achieved some success with this proposition.

Whether any of this could be preserved in negotiations built around spot prices is surely a consideration.

But the real issue is whether the Chinese customer prefers to keep term contracts or would willingly embrace the idea of buying at spot. Of course, we must assume that, if Rio - and BHP - want to change to spot, they have identified some commercial advantage for them in such a change. How can they, we might wonder, convince China that both buyer and seller will be better off?

We might also ask, what about Australia's national interest in all this? The companies - and perhaps the Chinese - will say that is not an issue: pricing is a commercial matter to be sorted out between buyer and seller.

But if we look a little more closely, we might discern that there is a range of broad national interests to consider. For better or worse, successive governments, including Mr Rudd's, have succumbed to the idea that we should put most of our export eggs in the mineral commodities' basket. Much of our national prosperity hangs on Australia exporting large volumes of commodities. Today, China is the big buyer on whom we are utterly dependent.

Mining companies seem to think the opposite is true. Short-term they might be right; but there is plenty of ore and coal around the world in yet undeveloped reserves. China knows this and its attitude towards what it does in seeking new sources will, in part, be conditioned by how much it believes it can rely on us.

Furthermore, don't forget that if the circumstances suited it, Rio and BHP could well team up with China to develop mines outside Australia.

In short, if China believes its Australian sources are not taking full account of its interests, it will look elsewhere to develop new suppliers - probably in deals where it holds an equity interest. Maybe it is already doing so.

All of these considerations certainly touch upon our national interests.

However we look at it, our government must be interested in how our mining companies manage their commercial relationship with China. It is not enough to look back and conclude that the miners managed their relationship with Japan pretty well - which they did - and there is nothing to worry about.

China is, however, a different proposition. Japan grew into a major economic power, but it was not politically significant. For all kinds of reasons, including its defeat in World War II, it chose not to be.

China admits to no such constraints. It is a major political and economic power. We are seeing this in its actions in holding some of Rio's negotiators on serious criminal charges. It has an unusual and perhaps flexible interpretation of what it regards as matters of "state security".

Matters, which might in other circumstances be left entirely to commercial parties, must, when it comes to China, involve our government. Never forget, that on the Chinese side, it is the Chinese government with which we are ultimately negotiating.

Mr Rudd and his team must learn how effectively to manage the various national interest considerations associated with selling commodities to China. All of the free trade rhetoric being proclaimed around Canberra won't help them much. As a start they could try to develop, with the help of the public service, closer links with the companies.

Colin Teese is a former deputy secretary of the Department of Trade.

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