Iron ore prices have recently been in the headlines, having jumped 85%. 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 George W 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 75% of total global production. Moreover, the
oligopolistic power of the producers is reinforced by geography. Vale do Rio
Doce is Brazilian and based 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, reflected in steel
company stock prices. For instance, consider US Steel, which traded at US$12 a
share five years ago, and in June 2008 peaked at $196.
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, Big Steel has been forced to cough up some of its
oligopoly profits, turning them into Big 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 George W 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.
Thomas I Palley is the founder of the Economics for Democratic and Open
Societies Project.
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