High Noon for China and Rio Tinto

Steel VatIf China’s leaders were ever wondering what else to do with the country’s massive foreign currency reserves, BHP Billiton has just given them one idea: take US$130 billion or so and buy Rio Tinto. BHP’s offer last week to merge the two companies by offering three of its shares for every one of Rio Tinto’s has put the giant mining company in play, and China is the ultimate strategic buyer. China should seize this opportunity, for both offensive and defensive reasons.

With 500 million tons or more of steelmaking capacity, China has over one-third of global capacity and is, by far, the largest steelmaking country in the world. As a result, it is also the world’s largest customer for iron ore. And that is precisely the reason why making a play for Rio Tinto makes so much sense for the country.

The global iron ore industry is dominated by three players today: Brazil’s Companhia Vale do Rio Doce (CVRD), Rio Tinto and BHP. A combined Rio Tinto and BHP would exceed CVRD’s almost 300 million tons of production, and account for 41 percent of seaborne production. CVRD would be nearly equal in size with the new company and would account for 38 percent of seaborne production. If the merger goes through, 79 percent of the world’s iron ore supply would find itself in the tight grip of a powerful duopoly. The State of India, with just under 100 million tons of production (which it already finds difficult to get to market due to infrastructure bottlenecks) would be a distant third.

China’s steelmakers should be worried about this potential outcome. Despite its size, China’s steel industry is vulnerable because it is caught in the middle—between the powerful iron ore suppliers on the one hand, and a diverse group of customers for steel products on the other. Australia supplies 37 percent of China’s iron ore imports, Brazil 25 percent and India 21 percent.

Steel customers—automakers, appliance manufacturers, construction companies, ship builders and a host of other industries around the world— have had no choice but to accept higher steel prices in the past, passing along what costs they can to customers, and eating what they can’t. But this game can’t continue. How long will consumers go on accepting higher prices? How long can manufacturers keep taking it on the chin in the form of deteriorating operating margins? Rising inflation expectations in every part of the globe are making it even more difficult than it has been to pass along raw material costs to consumers, and recession worries in the U.S., still the largest economy in the world, threaten to reduce global demand.

This raises the possibility of a fairly ugly scenario for China’s steel industry, which has invested so much of the country’s resources in building capacity, and for any steelmaker around the world that isn’t vertically integrated. In the face of falling demand and consumer resistance to higher prices, non-vertically integrated steel producers, like China, will have to deal with a powerful duopoly which can name its price as far as raw materials. This has already been a problem with three companies, CVRD, Rio Tinto and BHP, dominating global production. Over the past several years, the three iron ore suppliers have pushed through a series of large price increases, the largest of which amounted to a 71.5 percent increase in 2004. Even without the merger, steelmakers are concerned that next year’s price increase could reach 50 percent.

Based on CNOOC’s unfortunate experience trying to buy Unocal, a second-tier oil producer, a Chinese government controlled entity buying one of the largest iron ore producers in the world would surely draw political fire from every corner. But isn’t that far better than having the world’s iron ore supplies concentrated in the hands of only two companies? In this case, I would argue that China’s interests and those of the global economy are nicely aligned. ArcelorMittal and U.S. Steel, two of the world’s largest steel producers, already have their own sources of iron ore supply. Why shouldn’t China?

Allowing Rio Tinto to fall into the hands of BHP would be detrimental to China’s interests, as well as the interests of the global economy. In my view, China can’t afford to sit this one out. As a user of steel products, we will be cheering the country on if it decides to enter the fray. Every other consumer in the world should be as well.

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