Size may not matter in driving down rising steel costs

The mega merger between Japan's Nippon Steel Corp and Sumitomo Metal Industries may improve competitiveness against lower-cost rivals, but might do little or nothing in cutting soaring raw material costs.

A move by producers to use contract pricing closer to spot prices for iron ore and coking coal, the key ingredients in producing steel, has weakened any bargaining power buyers had with the annual price-fixing regime in previous years.

"Being a bigger entity doesn't necessarily demand pricing power at the moment because the producers are equally sizable," said James Wilson, analyst at Royal Bank of Scotland in Perth.

"They'll have a better seat at the negotiation table, but not necessarily in determining the actual price."

Japan's No1 and No3 steelmakers on Thursday announced plans to combine their operations in a deal expected to be worth more than USD 11 billion.

A combined Nippon/Sumitomo will have a 3% share of the global steel market, versus the two-thirds of the seaborne iron ore market that is controlled by global miners Vale, Rio Tinto and BHP Billiton. BHP is also the world's largest supplier of seaborne hard coking coal via a joint venture with Japan's Mitsubishi Corp.

Producers began pricing iron ore and coal contracts on a quarterly basis beginning last year in a bid to more closely reflect market fundamentals and cash in on spot prices that, in the case of iron ore, more than trebled in 2010.

Tight supplies have pushed iron ore spot prices to near a record USD 200 per tonne this year and coking coal is also making its way toward USD 300 a tonne, the all-time high last seen in 2008.

"The new entity will have more power to attract input tonnes but it's hard to see how, with 3% market share, it will influence the price," said Trent Allen, analyst for Resource Capital Research.

"Not even the Chinese mills in their combined might were able to stop iron ore's Big Three from hoisting contract prices."

No choice

Baoshan Iron and Steel, China's biggest listed steelmaker, has been leading iron ore price negotiations with miners for Chinese mills but usually is left with no choice but to accept prices imposed by Vale, BHP and Rio.

Those contract prices are based on indexes that reflect spot market movements in the previous three-month period, although BHP has been increasingly moving to a more flexible monthly pricing arrangement.

"Controlling the index means controlling the spot market, and who can do that?" said Allen at Resource Capital.

"If anyone, and realistically, only the miners. Iron ore prices will stay high until steel demand drops or downstream consumers kick against the increasing price of rebar and cars and barbecue tongs."

Still, shares of Nippon Steel and Sumitomo Metal soared on Friday as investors welcomed their plans to create the world's second-biggest steelmaker to compete more effectively with rising Asian rivals.

"I expect they want to get together so they can stand up better against the raw materials suppliers," said William Adams, analyst at UK-based FastMarkets.com.

"Big is beautiful in these industries. I would be surprised if we don't see more of this. Companies are sitting on a lot of cash and things are looking brighter for the future," he added.

China, the world's biggest steel producer, whose output was around six times that of second-ranked Japan in the past two years, is similarly attempting to consolidate its fragmented steel sector and encouraging big state-owned mills to swallow up smaller rivals.

But steel mills may have to wait until the supply situation improves before they get the upper hand in contract pricing.

It may take time before coal mines in top exporter Australia recover fully after disastrous weather disrupted operations and significantly more iron ore capacity may not come online until 2012.

Iron ore miners are expanding production to meet booming demand and analysts say that could lift global seaborne iron ore supply by around 100 million tonnes annually from next year, about five times the current annual rate of increase, which could knock spot prices down and turn the tide in favour of steelmakers.