The announcement this week that Japanese and Chinese steel companies were moving to three month contracts with suppliers of iron ore, abandoning the previous annual price negotiations, is significant in a number of ways. All of them however add up to higher global inflation and lower overall economic welfare.
It may reasonably be argued that an annual price negotiation in which one party, China, the owner of majority holdings in the major Chinese steel companies, imprisons the other party’s negotiating team for a decade when talks break down is too one-sided to be tolerated. The abandonment of the four Rio Tinto executives by the company after their sentencing was also an act of corporate pusillanimity abject even in the China trade and will do major long term damage to Rio Tinto’s operations worldwide. However, while civilized negotiations with Chinese counterparties may be becoming impossible the alternative, of transacting all iron ore sales in the short-term market, will impose immense economic costs.
Start with the direct effect of the change. Iron ore prices in the new contracts are 90-100% higher than in the contracts signed a year ago (or, in China’s case, not signed.) Spot prices are currently 30% higher than the new contract prices, so when the new contracts expire in three months, it is likely that iron ore prices will rise further. These price increases will be passed on by the steel manufacturers to the cost of all goods that use steel, which represents about 95% by weight of all items made with metal.
In other words this rise in iron ore prices to record levels is pretty well equivalent to a doubling in the price of oil. Steel is somewhat less important than oil in the world economy, but on the other hand the elasticity of steel consumption as prices rise is less than that of oil, if only because many steel products have a value much higher than that of the steel they contain.
The contention of the world’s central bankers that inflation is not currently a danger is thus revealed to be pure fantasy. Now that global economies have bottomed out, workers have sufficient bargaining power to maintain their living standards, with possible wage reductions in the West being balanced by above-inflation rises in the booming economies of China and India. Inflation is already running well into double digits in India and is close to that level in China, although official statistics in China remain heavily massaged. With the price of raw materials doubling in a year, and that of the great reserve pool of cheaper labor increasing at double digit rates, the West’s 25-year holiday from inflation can be declared officially over, starting no more than a month or two from now.
There is however a secondary effect of the changes in the iron ore market, which is likely to entrench inflation in the global economy for decades to come. That is its move towards increased spot trading, and the commensurate increase in importance of the iron ore derivatives market, forecast by the Financial Times to grow to a $200 billion market (given that every other significant derivatives market seems to have outstandings in the trillions, this estimate seems low.)
If you examine the effect of derivatives on other commodities, it becomes apparent that their principal effect is to increase price volatility, as well as possibly causing an upward bias. Gold, which has been traded primarily on a spot basis, with derivatives attached, since 1973 has been far more volatile in its derivatives period than it was before 1973. More significantly oil prices, which before 2000 moved relatively infrequently in spite of the 1970s price jumps, have since that date become far more volatile. They doubled between 2003 and 2007, doubled again in 2007-8, collapsed by three quarters in the space of a few months, and have now recovered to a level far above pre-2007 norms, that if sustained will cause global economic disruption.
Before 2007, the iron ore price moved only modest amounts, the annual fix rising or falling a maximum of 15-20% and remaining within a range of $24.30 and $32.50 per tonne for the entire period 1982-2000, for example. That is clearly now changed; iron ore prices, like oil prices, will be capable of doubling or halving within a few months and will fluctuate wildly as the activities of derivatives speculators push the price far beyond economic reality in both directions. Naturally all these fluctuations will be immensely beneficial to the speculators involved, probably mostly the usual Wall Street behemoths.
It will however make life immeasurably more difficult for everybody genuinely involved in the production chain for iron and steel. It’s no good claiming that price fluctuations can be hedged through the derivatives market. That can be done with adequate liquidity only over a year or two and there’s always the danger that you guess wrong on the hedging. An iron ore producer who had played safe last year and locked in a sales price of $50 per tonne for the next five years would not only find itself looking pretty silly currently, it would also be at a huge competitive disadvantage as labor, shipping, mining equipment and other costs rose over time to reflect a world in which the spot price of iron ore is $150 per tonne. Likewise, a steel producer that locked in an iron ore supply price somewhat below the current spot market over the next five years might find itself hopelessly uncompetitive in cost if iron ore prices dropped once again to $50 per tonne.
The idiocies of modern accounting provide an additional destabilizing factor. Under FAS153, the derivatives positions used to hedge an economic exposure must be marked to market. If a company is hedging its output or purchases 2-3 years forward, it is then subject to wild swings in profit from movements in the value of its derivatives position. For example, oil royalty trusts which in mid 2008 hedged their sales forward through 2010 at prices over $100 per barrel were economically very intelligent (or lucky) as the price has averaged well below this level. However the value of their hedges, being 2-3 years’ sales, vastly exceeded the value of their annual revenues from operations. Thus when prices dropped in late 2008 those companies reported gigantic profits, just as their oil in the ground became much less valuable. Then in 2009 as prices recovered they were subject to huge losses as the actual long-term economics of their business became viable once more. For investors and bankers, the companies’ income statements became wholly inscrutable; it was impossible to determine whether or not they were making a profit on an operating basis. Needless to say, derivatives hedging, while protecting “economic” value in some mystical sense, had done nothing whatever to protect the stability of the companies’ profit streams.
Even more damaging is the question of capital investment. That’s not too difficult for steel companies, which can assume that the margin between their cost of iron ore and their price for products will remain approximately constant. However it’s impossible for an iron ore producer considering its exploration budget or a major capital investment in a new mine – it can have no real idea of what iron ore prices may average over the life of the mine.
This has already proved heavily damaging in the oil business, where the derivatives wizards and wildly fluctuating prices have been active for a decade now. For the traditional producers in the Middle East, there is the question of how large a welfare state they can afford – they can use oil funds to cover fluctuations, but this becomes more difficult when the long-term price trend is unclear, as now. Even more difficult has been the problem of the Canadian oil sands producers, at $40 a barrel hopelessly uneconomic, at $147 or even $85 the economic salvation of both Canada and the West as a whole. Thus when oil prices collapsed in late 2008 over $90 billion of oil sands projects were delayed or cancelled. Needless to say, as oil prices have risen past $80 those projects have mostly been pulled out of mothballs. Such messing around is very expensive indeed; indeed may even have produced costs for the global economy larger than the vaunted profits racked up by the oil derivatives business during the period.
The move to spot trading and a derivatives market in iron ore is thus thoroughly negative for the global economy. It increases the rents extracted by the bloated traders of Wall Street, while imposing gigantic costs on everybody else. Almost certainly, it will result in higher inflation and shortages of supply, as bankruptcies and project cancellations in periods of low prices, together with speculator hoarding of physical product, cause price spikes and shortages of iron ore during periods of market frenzy. This already seems to be happening in copper, another raw material vital to the global industrial economy.
The reality is that the move from long term price fixing to speculative casino, however profitable it may be for the croupiers of Wall Street, is thoroughly bad news for the rest of us. Far from imprisoning their counterparties in the annual price negotiations, the Chinese if they were wise would beg them to return to the bargaining table, so that the great majority of iron ore trading can once again be locked up year by year by a fixed price negotiation, and the casino can be relegated to the fringes where it belongs.
The crash of 2008 should surely have taught us that many of the profits reaped by Wall Street are pure rent seeking, the extraction of value from others’ economic activities by disrupting ordinary business relations without providing anything economically worthwhile in return. The decade or more of cheap money imposed on us by Ben Bernanke, his foreign counterparts and their predecessors has exacerbated this rent extraction tendency. It’s time to reform the system, initially by raising real interest rates sharply, before Wall Street succeeds in reigniting inflation and impoverishing us all.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)