Thomas Palley: Iron Grip

I don't know much about the specifics of this market, but Thomas Palley says it is far from competitive, and a recent Bush administration decision will reduce competition even further.

[There is one point where I'd disagree, though it's not about the market structure point, it's the claim that "rampant" speculative trading is responsible for the run-up in commodity prices generally. I think fundamentals are the main driving force.

A more subtle point is that if, as Thomas claims, market structure is responsible for the price run-up, then "the iron ore market doesn't have speculation yet it's prices went up too" argument against the claim that speculation has caused the run-up in commodity prices is undermined (see the first link above for one example of this argument). However, recent data on inventories in oil markets and elsewhere work strongly against the speculative hypothesis for the commodity price run-up. In addition, since the commodity price run-up looks similar across markets with differing market structures, e.g. from competitive agricultural markets to non-competitive iron ore markets, market structure does not appear to provide a general explanation for the commodity price increases (and market structure is, in general, probably a better explanation of the level of prices than the change). But I'm not sure Thomas intended to make this point, and the lack of attention to non-competitive market structures in recent years is an important point that I don't want to obscure with this discussion.] [Update: Corrected version - fixes pig iron references]:

Pig Iron versus Cold Steel, by Thomas Palley: Iron ore prices have recently been in the headlines, having jumped eighty-five percent. This news is troubling as such price increases threaten to raise steel prices, which will add to cost inflation and further undermine economic activity.

Behind these price increases lies the unusual structure of the iron ore market which is best characterized as bi-lateral oligopoly. That structure makes enormously troubling the Bush administration’s decision to give regulatory clearance to a combination of the number two (Rio Tinto) and number three (BHP Billiton) ore producers.

Unlike other commodity markets, iron ore prices are set through annual negotiations between the ore producers (Big Iron) and the ore users (Big Steel). Recent contractual negotiations have resulted in huge price increases that reflect the ore market’s structure.

On one side is Big Steel, consisting of an increasingly few large steel producers. On the other side is Big Iron, made up of an even fewer number of ore producers. Thus, the top three producers – Vale do Rio Doce, Rio Tinto, and BHP Billiton – account for seventy-five percent of total global production. Moreover, the oligopolistic power of the producers is reinforced by geography. Vale do Rio Doce is Brazilian and located in the western hemisphere, while Rio Tinto’s and BHP Billiton’s operations are in Australia. That creates a geographic split that helps Big Iron’s profits.

In recent years steel production has been marked by significant mergers and right-sizing of capacity, combined with growth of state-directed steel capacity in China. The result has been a huge boom in steel profits that is reflected in steel company stock prices. For instance, consider U.S. Steel that traded at twelve dollars a share five years ago, and in June 2008 peaked at one hundred and ninety-six dollars a share.

Big Steel’s earnings rolled in first, being at the end of the production chain. Now, Big Iron is trying to muscle in on the action and grab a share of those profits for itself. It is able to do so because of its bargaining power, and it would be no surprise if there also were some informal collusion among ore producers given their small world.

With limited alternatives, Steel has been forced to cough up some of its oligopoly profits, turning them into Iron’s mining rents. That is a bad switch. Higher earnings in iron ore mining will have negligible impact on their economic plans as the industry was already earning large excessive profits. However, higher ore prices will raise steel prices, undermining manufacturing and causing inflation. Meanwhile, lower steel profits will reduce steel investment.

Lastly, speculation may also have contributed to the jump in ore prices, albeit not the speculation associated with other commodity markets in which speculative trading is rampant. Since iron ore is not traded on global commodity markets, financial speculators cannot be responsible for higher prices.

Instead, iron ore speculation is best characterized as ‘joint speculation” by the ore producers and users about the continuation of steel profits and the ability of steel companies to pass on higher costs. In this light, the jump in ore contract prices can be viewed as a combination of profit capture by the ore producers plus a big bet on future macroeconomic conditions.

Such user – producer speculation is hard to argue against, but one can argue against an oligopolistic market structure that amplifies speculation’s destructive effects. That makes the Bush administration’s decision to approve a Rio Tinto – BHP Billiton combination another terrible public policy decision.

The approval of combination reveals the worst proclivities of the Bush administration, which is peppered with extractive industry boosters, particularly oil. The quest for combination shows that the much maligned Karl Marx was right about capital’s proclivity to combine.

Comments

[ddt]

well the bottom is falling out of the iron ore market as we speak, and coal as well - so now might not be the best time for this article.

Is coal the stock market’s canary?
With London equities market wafting in and out of bear market territory on Thursday - a response to the 1.8 per cent drop on the S&P 500 overnight and a 1.46 per cent fall on the Dow - attention turned in the unlikely direction of over-the-counter thermal coal.
After a sharp run up, Wednesday saw a swift correction:
...
Jitters seem to have been triggered by reports that Asian steelmakers were refusing to pay latest coal prices - complaining (with some justification, no doubt) that they were not able to pass on inflated costs to their own customers.
Indeed, in the US the head of ArcelorMittal’s local flat-rolled business, Lou Schorsch, was quoted by Bloomberg as saying that about half of his US customers had refused to pay a $250-a-ton surcharge added by ArcelorMittal in May.
That in turn has rattled the mining industry in general — all the big London-listed miners were headed lower on Thursday.
A small yellow bird may just have fallen off its perch."

http://ftalphaville.ft.com/blog/2008/07/03/14283/is-coal-the-stock-markets-canary/

that pesky demand destruction...

Coal, iron ore stocks hit hardest
By Matt Chambers
July 04, 2008 12:00am
Article from: Font size: + - Send this article: Print Email
MORE than $25 billion was wiped from Australian resources stocks yesterday as falling coal prices and concerns that record oil prices would begin to weigh on global growth started a rush for the exits. ...
http://www.news.com.au/business/story/0,23636,23967162-462,00.html

[S Brennan]

I've tried to shorten this to the point where "fair use" is applicable. The article is biased, but it contain much good info on UP iron deposits. The article should be read in full:

http://www.resourceinvestor.com/pebble.asp?relid=28202

An Industry Is Aborning: Nickel Mining in Michigan

By Jack Lifton
18 Jan 2007 at 03:40 PM GMT-05:00

DETROIT (ResourceInvestor.com) -- Michigan’s Department of Environmental Quality (DEQ) has recommended that a permit be issued for the construction of what is to be the only primary nickel mine in the United States to the Kennecott Eagle Minerals Company, an operating entity of Utah’s Kennecott Minerals, which is itself a wholly owned subsidiary of Britain’s Rio Tinto Group [NYSE:RTP; LSE:RIO].
...

Life was good in Michigan especially for automotive industry executives and the OEM automotive industry’s hundreds of thousands of workers and managers.

In the ensuing decade, from 1994 to 2004, Michigan’s dominant industry shrank to the point of collapse under the weight of globalization. Bankruptcy was routinely put forward as an option. American OEM auto industry executives said that the low labour costs, particularly enjoyed by Asian manufacturers, were crushing an American industry that had an irremovable baseline “legacy” cost for labour, pensions, and healthcare due to, what could only now be seen as, overly generous commitments made during the American auto industry’s halcyon days, which the managers of the time had thought would never end.

The CEOs of the American OEM automotive industry in 2004 had been hired, trained and promoted by the same CEOs whose legacy-creating decisions they now blamed for their industry’s woes. They still, however, thought exactly the same way as their predecessors. Namely that short-term fixes would hold everything in place until the market “cycled” for them. All of this market turmoil, they believed, had happened before and would happen again. Their thinking therefore remained short sighted and fixated on pleasing Wall Street’s increasing focus on short term gains.

For example, they ignored, and thereby maintained their own disastrous corporate legacy of not planning for risk management of raw materials. No financial staff were allocated to risk management of anything other than foreign exchange and only one American OEM automotive manufacturer, GM [NYSE:GM], even had ever had a professional group within its purchasing operations that oversaw the purchasing and risk associated with the acquisition of precious metals for catalytic converter production and of base metals used in production for which there was a futures market in which to hedge (e.g., copper, aluminium, nickel and tin).

The divesting of their parts operations by the American OEMs in the late 1990s masked for them finally and almost completely the issues of raw material availability and price volatility. They became someone else’s problem. Once these issues were twice removed they were basically ignored by the Big (Two) Three’s top management.

...

The existence of commercial deposits of high grade sulfide ores of copper and lower grade ores of iron in the UP was well known, but environmental fervour in 1994 conflated sulfide with noxious sulfur dioxide and corrosive sulfurous and sulfuric acids produced not only when the ores were “roasted” to begin the smelting process, but also over the long term by oxidation of the ores and residues when and if exposed to the oxygen in the air.

A turning point though came when Kennecott Minerals discovered and mapped a high grade ore body in Michigan’s Marquette County near the southeastern shore of Lake Superior, and found it to contain more than 3% each of copper and, to their surprise, nickel, both in the form of sulfides. The 4-6 million tonne ore body, at current, January 18, 2007, market prices thus contained between $4.2 and $6.1 billion of recoverable value.

Michigan’s 2004 legislature beset by the collapsing OEM American automotive industry and the concomitant collapse of Michigan’s economy was open to new ideas, and, as it turned out, to the revival of old ideas made safer and cleaner with modern technology. The legislature was much more willing to listen to both sides of the environmental argument in 2004 than its predecessor had been in 1994.

...

Smaller mining companies still avoided working in Michigan, because even with the advent of modern safe and environmentally satisfactory technology the costs of fanatic opposition measured as litigation costs were prohibitive.

One major company, however, the Rio Tinto Group, a global giant, which is one of world’s three main producers of iron ore, which has soared in price in this century, thought Michigan’s UP well worth another look. Rio Tinto’s Kennecott Minerals subsidiary a major producer of copper in Utah, where Rio Tinto is actively pursuing the development of iron ore deposits, was given the green light to look at opportunities in the UP in the late twentieth century before the new Michigan mining law was even drafted..

Kennecott Mineral’s, Eagle Project, discovery of high grade nickel and copper brought about the change in attitude by this major company that the Michigan legislature had hoped for, and, with commodity metal prices soaring and a nickel shortage developing, they decided to make an attempt to develop the Eagle Project. Kennecott, operating within the amended (in 2004) Environmental Act of 1994, has been able to successfully show the DEQ that it has faced and solved the problems that previously led to objections and then rejections for projects to develop sulfide ore mining in Michigan.

The global market for nickel and copper is so high that in fact Kennecott projects that it will make a profit bringing up the ore to the surface in covered containers, concentrating it, transferring it to covered railcars, and transporting it for smelting and refining to Sudbury, Ontario.

...

Michigan’s unemployment rate is officially today 7.1%. A simple car ride through the Saginaw Valley past the former automotive manufacturing centers of Flint, Saginaw and Bay City may convince you that the official unemployment rate may well be understated by as much as 100% to 200% for those cities, but environmentalists aren’t interested usually in checking those statistics.

The real issue for the opponents of the Eagle Project is that the proximity of this small and well defined ore body to Ontario’s Sudbury Mining District is an indication that there may well be many other such ore bodies both in upper Michigan and just under the water of nearby Lakes Superior and Huron, which were both created by glaciers, so that their underlying geology may well be the same as that of the nearby dry ground, i.e., the eastern UP and northwestern Ontario.

What no one has yet discussed is the high probability that the Eagle ore body, as well as the as of yet undiscovered, similar ore bodies in the UP contain platinum group metals just as the nearby Sudbury deposits do. Sudbury is the world’s third largest producer of palladium. It is also synonymous with nickel production.

Michigan’s amended environmental law can be a trial balloon for the revival of mining in the area. It requires that the mining company making an application, even to prospect, first address all of the safety, health and species protection issues beforehand, that solutions to all be proven viable before the project starts, that the company be financially responsible for the life of the mine through not only the application and holding of sufficient capital but also by buying insurance and bonding, and that it return the land to its original state when the project is finished , terminated or abandoned.

Please read Michigan’s Nonferrous Mining Regulations for a trip to a hopeful future for American natural resource recovery.

To paraphrase “Engine Charley Wilson,” the CEO of GM in 1954, perhaps what is good for Michigan is good for America.

[Bruce Wilder]

Oh, absolutely Brennan. Now would be the ideal time to pollute the largest, purest body of freshwater on earth!

[Bruce Wilder]

Is it possible that the commodity price run-up is just the mirror image of a value-of-the-dollar run-down? And, that the "speculation" taking place is speculation in the value of the U.S. dollar currency. Plenty of inventories of greenbacks around.

[Klatoo]

As a metallurgist, I find the conflation of the word Pig Iron with Iron Ore more than a little irritating.Iron Ore is the mineral Iron Oxide, a solid which occurs in a natural deposit.Pig Iron is the product of the Reduction of Iron Oxide to molten iron with metallurgical coke.This reduction occurs in a blast furnace.

Steel is the result of the oxidation of molten pig iron with oxygen.This occurs in a basic oxygen furnace.The resulting product is cast in a continuous casting machine and converted to a myriad of products.

There is also another route to steel that does not involve producing pig iron in a blast furnace with coke.That is a process called the direct reduction of iron ore which uses reformed natural gas to reduce iron ore.The resulting product is called Direct Reduction Iron (DRI) which is produced at many locations in the world now where natural gas is plentiful.Trinidad ( where Arcelor Mittal operates a plant),Venezuela,Quebec,Algeria, Qatar and other locations do not produce pig iron at all and use the DRI to produce steel.

An economist who does not know the distinctions in the processes or the products from iron ore to steel is not worth listening to.

[kthomas]

Klatoo, thx for the info. I learn so much on Prof Thoma's blog!!!

[mik]

An economist who does not know the distinctions in the processes or the products from iron ore to steel is not worth listening to.

But people who love to analyse spherical cow (en.wikipedia.org/wiki/Spherical_cow) are too important and smart to bother with little dirty details.

[Klatoo]

The monopoly practices Mr.Palley worries about,ignores the many countries like India which is an integrated steel producer with a large production capacity of its own.India has vast iron ore deposits that are being activated as the price of iron ore goes into the stratosphere.

The steel market which for long time was moribund is coming alive because of the vast infrastructure projects in India and China.When this deman abates we can expect normal prices to resume as demand destruction will resume.Then, Mr.Palley will have something else to worry about or more likley worry us to death about and that will be not enough profitability in the steel business.

C'est La Vie.

[Klatoo]

I also want to mention that a major portion of the world's steel production now occurs in mini mills of the type pioneered by Nucor.Those minimills do not use iron ore or pig iron at all but use scrap steel that is melted and converted to steel in electric arc furnaces.Not only do these furnaces shorten the steel cycle but they require vastly less capital than the integrated steel producers that start from the iron ore.Their labor costs are also negligible per tonne of steel.

These alternatives available to steel producers act as brakes on runaway cost increases even a giant like CVRD in Brazil is not able to enforce.What is unique at this stage is the massive demand coming from India and China as they modernize.

Thank you for your comments.