[in safe hands] how big business operates

This Sydney Morning Herald article on Rio Tinto's iron ore battle with China - the final round of brinkmanship from last year, illustrates how close we often come to the brink and the escalation of hostilities. Even if steel is not your thing, this still makes a rivetting read:

It took place at a Baosteel office in Shanghai. Baosteel, China's industrial champion, and Rio Tinto, the world's second biggest miner, had already weathered roughly a round a fortnight since February without any sign of progress. The talks began after lunch with Baosteel's chief negotiator Ding Shouhu flinging threats and statistics at Rio Tinto's Will Malaney, as usual, and Malaney returning in kind.

Baosteel was insisting on a price rise close to the 71 per cent agreed with Brazil's Vale four months earlier. Rio Tinto was after nearly double that, to bring prices in line with China's sizzling spot market.

It was a strategy of mutually-assured destruction. If they failed to find common ground that day, [it would plunge] the Australian mining industry and Chinese steel makers into an unpredictable world of spot market sales and retaliation from Chinese industry and government. For weeks Baosteel had been privately promising a blanket Chinese embargo of most or all Australian iron ore cargoes if negotiations broke down and Rio knew there was a real chance that Baosteel and its controlling shareholder, the Chinese Government, would follow through on the threat. Nobody knew where that might lead.

"I've experienced times when politics have been unleashed in China," says a Chinese negotiator, "and it has been very hard to control."

The Rio and Baosteel negotiators edged towards each other in a haggling process not unlike what you might see in a Chinese clothing market. Baosteel gave a little, Rio gave a little. They agreed that China and Rio Tinto would be better off if the price of "lump" iron ore rose faster than "fines", as lump accounted for a relatively small proportion of China's imports compared with Japan but a relatively high proportion of Rio's exports compared with BHP.

And then after 12 months of talks, four months of serious negotiations and a tense afternoon in that room at Baosteel, the opponents jumped up and clasped each other's hands. They had agreed on a record-breaking 79 per cent price rise for iron ore fines and a 96.5 per cent rise for lump - working out to a weighted average rise of 85 per cent for Rio Tinto and a little less for BHP.

Australia had helped itself to an extra $2.5 billion in annual export earnings [but] from China's point of view, its economy suffered yet another terms of trade shock, its inflation problem got worse and its steel industry leaders lost face. But the mills would continue to expand and an all-out trade war had been averted.
For now.
In recent years Australia's big mining companies [had] underestimated China. The head offices of both BHP Billiton and Rio Tinto initially closed their ears five years ago when their analysts in Shanghai and Beijing began screaming down the phone to say the steel industry was taking off and they didn't have nearly enough supply to meet demand. Decision makers said mine expansions were too difficult, skilled workers were too scarce, the China boom wouldn't last.

In 2006 Rio Tinto surrendered the Chinese market leadership position it had occupied since 1973. Vale powered ahead, despite Brazil's ports being three times as far away as Cape Lambert in the Pilbara. The tardy Australian mining response became a macro-economic problem as Australia's overall export volumes hardly moved in six years.

BHP chief executive Marius Kloppers … understands that steel has an almost "spiritual" dimension in China and that Chinese political leaders have something of a steel obsession. And yet … BHP did nothing to prepare China for its takeover announcement [of Rio Tinto]. There had been no warning, no reassuring courtesy call, and no joint investment offer as a gesture of goodwill. Instead, BHP put the bulk of its early public relations efforts into London.

"BHP and Rio are so powerful already," [said] Hu Kai, a leading iron ore analyst at Umetal.com. "Together, they would control the world's iron ore exports and set the price absolutely. There is no question about this. Baosteel is very scared."

Rio Tinto [was] also scared. BHP is a smaller player in the iron ore market but in recent years it has been far more aggressive. Privately, BHP blame[d] Rio's "gutlessness" for its failed attempt to secure a freight premium for Australian exports to north-east Asia three years ago. Rio … kicked off the year by picking a major fight with Chinese mills by dumping millions of tonnes of long-term contract iron ore onto the Chinese spot market, in breach of the spirit if not the letter of the "contingency" provisions of its agreements.

CISA's big-talking president, Luo Bingsheng … recently gave an extraordinary account of his own strategic importance on national TV. He told China Central Television that he had summoned the "iron ore manager of Rio Tinto" - perhaps Rio's veteran behind-the-scenes negotiator Ian Bauert - and delivered a message that was polite but barbed like "needles in cotton".

Luo conceded that Rio Tinto's new-found fortitude had taken him by surprise. "We failed to consider Rio Tinto's strong attitude in negotiations," he said. And then Luo unveiled China's doomsday weapon. He had personally drafted an edict that he intended to immediately publish if that last round of negotiations broke down.

"It said the breakdown of the negotiations totally violated the traditional pricing mechanism and China's steel enterprises will resolutely boycott the switch from long-term contract ore to spot market ore," said Luo. CISA was willing to choke Chinese steel makers in the hope it would cause relatively more damage to Rio Tinto. "If [Rio] loses the China market, it would be hard for the company to survive. If the negotiation fails, then BHP would be the biggest winner," said Luo.

Mutually-assured destruction

LUO's comments to the Chinese broadcaster CCTV mirror those of another senior iron ore and mining official, Zou Jian. In April Zou told the Herald that China was prepared to slash its steel production to by as much as 10 per cent - 50 million tonnes - if that was the price to be paid for blockading Rio and BHP ships after a collapse in negotiations.

Any state-orchestrated blockade would be in breach of the World Trade Organisation rules. But that is a technicality that has bothered CISA little in the past. CISA, a government offshoot, might claim that it was not a government organisation. In any case, a WTO dispute would take years to resolve.

From Rio's point of view, the strategic question was not whether CISA and Baosteel were bluffing but whether and for how long they could hold China's 700 steel makers in line.
RIO planned to sell … about two-fifths of China's total iron ore imports and about one-fifth of its total consumption. Over the year CISA had contrived to double China's port stockpiles to about 80 million tones. Some of the stocks were run down in the final month of negotiations in an attempt to depress the spot price and place more pressure on Rio negotiators. But they still added up to around two months of emergency supplies. CISA had also been tightening an import licensing system to increase its leverage. CISA could arrange to take away the license of any steel mill or trader that broke ranks. New cargoes from Australia's "third force" iron ore company, FMG, would also come in handy.

CISA's power base … would be haemorrhaging. They would be losing market share to China's smaller private mills and to the giant mills of Japan and Korea. And then it would be Japan and Korea's turn to face the newly emboldened Rio. [However], Chinese mills would eventually revolt and CISA would buckle. Privately, a senior CISA official told the Herald that Luo Bingsheng's war plan would not have worked.

In the end, Rio Tinto didn't get what it wanted but it broadly held its ground. For all the insults and bluster emanating from the China Iron and Steel Association this year, there was little it could do. While CISA taunted Rio with the prospect of being swallowed by BHP, close observers says Rio Tinto used the same argument against Baosteel to better effect.

"They presented this case: if China didn't agree to a much higher price then BHP would take over Rio and that would be terrible for China," says Hu Kai, at Umetal.com. "And they believed this. Baosteel believed that giving Rio a high price might help to stop the merger." Baosteel was doubly upset to learn that Rio and BHP had accepted deals with European mills at the lower Vale price. There are now two contract benchmarks: a global price and another higher price reserved for Australian iron ore in north-east Asia.

"The traditional benchmark system is breaking down," says Xu Xiangchun, an analyst at Mysteel. "There will be more change next year and the system will edge closer to Australia's demand for an index pricing system. The result will be several prices." But if BHP wins its takeover bid for Rio Tinto then all bets are off.

"If BHP gets Rio then next year there will be no price negotiations," says an Australian mining executive, half joking. "Baosteel will simply go to Melbourne and collect the price."

Update

Did the merger go through?