Menu Close

Competition the wrong test for iron ore inquiry

Prime Minister Tony Abbott says an inquiry into iron ore competition “could make sense”. Alan Porritt/AAP

Fortescue Metals Group Chairman Andrew Forrest has stepped up his campaign against competitors Rio and BHP, after gathering the support of independent Senator Nick Xenophon who is pushing for an inquiry into competition in the iron ore sector.

Forrest claims the miners are harming the Australian economy by flooding the market with iron ore, driving lower prices with a “predatory volume strategy”. Australian Competition and Consumer Commission Chairman Rod Sims says it’s hard to make a claim of predatory behaviour given the miners are still making a margin on their product.

Prime Minister Tony Abbott has said an inquiry “could make sense” in order to “get to the bottom on claim and counter-claim about what’s happening inside the iron ore industry at the moment”.

How we got here

Most Australians would know by now that the price of iron ore has fallen substantially over the last year. To get a sense of the decline, the benchmark price has fallen by more than 60% from around US$135 per tonne at the beginning of 2014 to below US$50, recovering to above US$60 recently.

This fall has been driven by two main factors. First, iron ore is essentially used for the production of steel. In turn, the demand for steel is typically driven by construction activity. New residential building construction starts in China, the biggest buyer of iron ore, declined by 14.4% in 2014.

Second, there has been an expansion in production by the world’s three largest miners: Rio Tinto, BHP and Brazil’s Vale. Together these three companies represent more than 60% of the international iron ore market. Moreover, all three major mining companies have plans to further increase supply.

Vale, for example, increased production by nearly 11% or about 12 million tonnes between the first and last quarters of 2014. BHP produced 59 million tonnes of iron ore in the first quarter of 2005, representing a 20% increase on quarter 1 2014, and approximately 77% of Vale’s production in the same period. Similarly, Rio Tinto increased iron ore production by 11% in 2014, to a total of over 300 million tonnes.

Collectively, the world’s largest iron ore producers (Vale, Rio Tinto, BHP Billiton, and the smaller Anglo American and FMG), increased sales by more than 140 million tonnes, around 10% of the total seaborne market, in 2014.

The market adjustment

The demand for iron ore is derived from the demand for steel, which in turn is derived from the demand for construction. This suggests the elasticity of demand ought to be fairly low. One estimate of the world’s elasticity of demand for iron ore suggests that a 1% drop in price leads to an increase in demand of only 0.24%.

Reserve Bank of Australia.

The low elasticity of demand suggests that the market will primarily adjust through changes in supply, with high cost suppliers being displaced by low cost producers and revenue falling. The chart to the right, reproduced from an RBA report, is helpful in understanding which miners will be displaced as a result of the drop in prices.

Indeed, this adjustment is already in motion. For example, China now imports more than 80% of the iron ore it needs compared to 70% two years ago. China’s iron-ore output has decreased by 9% in the first quarter of 2015. The impact is also being felt by smaller miners in Australia and in other parts of the world.

Moreover, the impact on revenue is also as predicted. While Australia’s exports of iron ore to China increased by 18% on a yearly basis, iron ore export earnings declined by 31% due to the fall in prices.

In a nutshell, while the larger miners are gaining market share, they are doing so at the expense of high cost miners and it is adversely affecting earnings. The diagram above also helps us understand why the ACCC has said that this process of high cost suppliers being replaced by low cost suppliers simply reflects the workings of a competitive market.

Where will it end?

The example of the airline industry price wars in the US following the 1992 deregulation is instructive. As a result of the price war, the industry lost all the profits that had been earned in its entire history.

Why would the large miners engage in a price war?

Andrew Forrest’s central idea seems to be that by increasing production, and causing such a large decrease in prices, large, low cost miners would be able to exclude small, high cost miners from the market. Presumably, once these high cost miners exit the market, the large miners would then recoup any profit sacrifices by using their market power to increase prices and profits.

Given large miners are not pricing below production cost, this is not your standard predatory pricing - and why the ACCC apparently has no concerns with the conduct. However, it’s not clear that production/extraction costs are the relevant costs for a predatory pricing test. As resources are finite, a tonne of iron ore sold today is one tonne less of iron ore sold tomorrow at likely a higher price. This is the opportunity cost of the resource and it is not clear why this should not be included in a predatory pricing test. These are complex issues that a parliamentary inquiry could independently look at.

Why it’s a policy issue

One may be tempted to think that this is essentially a business issue and that, in the absence of any anti-competitive implications, governments should simply stay out of it. This would be a costly public policy mistake as it would ignore the impact the price war has had, and will have if it continues unabated, on the value of the resources for owners.

The key is that because iron ore resources are finite, a lower price today may result in a reduction in their total value over the lifetime of a mine. The only case when this wouldn’t happen is if future demand for iron ore were to fall. This is unlikely as any decline in the demand from China, as it moves to its next stage of development, will be replaced by new demand derived from development efforts in India, Africa and the less developed countries of South East Asia.

In Australia, the Crown owns the resources and their value is captured both through state royalties, which directly benefit Western Australia where the bulk of iron ore resources are, and through corporate tax, which benefits both Western Australia and the country as a whole. The industry also has a significant impact on the broader economy.

The 2015 federal budget papers estimate that, since the last budget, the value of forecast iron ore exports has been downgraded by around A$90 billion. This has contributed to lower nominal GDP and has reduced forecast tax collections by around A$20 billion. This is roughly 57% of the public deficit in 2015-2016.

In Western Australia, the general government revenue estimates to 2017-2018 have been revised down by an unprecedented A$10.2 billion since the 2014-15 budget, driven by sharp declines in iron ore and crude oil prices. The revenue write-down in 2015-16 alone is A$3.9 billion, equivalent to 13% of the state’s total revenue base.

As the elasticity of demand for iron ore is low, this foregone revenue, or a return on ownership of mineral rights, is unlikely to be recovered in the future. It is essentially a transfer from the owners of the resources to buyers.

Will the price war end by itself?

Rio Tinto, Fortescue Metals Group, Arrium Limited, Grange Resources, and Vale’s production and exports of iron ore were reportedly lower in the March 2015 quarter than the December 2014 quarter. Vale, for example, decreased its output by 10% from the previous quarter and has announced it could temporarily decrease supply by 30 million tonnes. This, alongside an increase in Chinese demand for iron ore (despite a fall in its demand for steel), can possibly explain the recent partial recovery in the price of iron ore.

Given the expansion plans of the three large miners, and demand conditions, it seems the restraint shown by some of the miners in Quarter 1, 2015 may end, resulting in further downward pressure on iron ore prices. The Western Australian government budget papers, for example, assume a $47.5 price per tonne of iron ore for 2015-2016 and an increase in volume of 4.4%, on top of an increase of 13% in 2014-2015.

So what can a government inquiry accomplish? The inquiry is likely to focus on whether the conduct of the large miners is anti-competitive. The arguments I presented above suggest that the issues goes beyond competition law, or at least the ACCC’s interpretation of it, when examining finite resources owned by the Crown.

A second possible avenue for investigation, which could be pursued by the parliamentary inquiry, involves considering adding a public benefit test to any new production licence approvals or changing taxation arrangements to reflect the impact of business conduct on the value of the resources. For example, a tiered royalty regime could be set so that rates increase for very high volumes.

Want to write?

Write an article and join a growing community of more than 184,200 academics and researchers from 4,969 institutions.

Register now