I just read this article out of Australia regarding the Chinese iron ore negotiations. I want to remind everyone Steel Market Update's main Asia source predicted the failure of the Chinese in these negotiations. One of our analyst friends here in the United States told me recently it is not unusual for the government to get involved with negotiations (like the iron ore negotiations going on now) and ending up paying a premium over what they could have gotten.

China's Just Digging Itself a Deeper Hole

by: Matthew Stevens - The Australian

IF there was commercial motivation to China's detention of the Rio Tinto Four then its futility has been ruthlessly exposed by the daily news flow from the global seaborne iron ore market.

Yesterday alone we had confirmation of record quarterly production from Rio's Pilbara mines, indications that the spot iron ore market is tightening and news from Japan that Nippon Steel is moving to reopen one of two steel furnaces which were shut in February.

As each day passes, China's refusal to accept the iron ore price settlement forged by the Japanese Steel Mills looks ever more witless.

Back in May, Japan secured a 33 per cent cut in the benchmark price of iron ore delivered under contracts with Rio, leaving it paying about $US60 a tonne for contracted shipments through last year. Within a week that settlement had, as usual, cascaded through nearly all of Rio Tinto's other big Asian markets.

China should have followed suit, but the abacus said no. So China Inc folded its arms, pointed to demand fundamentals and told Rio Tinto, BHP Billiton and anyone else who would listen that it wanted a price cut of at least 40per cent.

Rio Tinto's refusal to entertain anything but the Japanese standard resulted first in a change of lead negotiator on the Chinese side of the talks with China's biggest steel producer Baosteel leaving the building, to be replaced by what is called the China Iron and Steel Association -- which is really the government.

Within weeks of the confirmation of CISA's status in the talks, Rio Tinto was delivered into a diplomatic crisis with the detention of Stern Hu and three of his staff on espionage and bribery charges.

In the meantime though, the dynamics of the iron ore market have shifted quickly, with the result that the spot iron ore price is sitting close to $US90 a tonne. That, of course, represents a premium of 50 per cent over the benchmark secured by Japan. That, in turn, would suggest Rio Tinto would actually be doing China a favour if it let them get away with a price reduction as big as the one secured by canny JSM.

There have been some reports suggesting Rio Tinto and BHP Billiton are somehow trying to manipulate the spot price by removing material from that market space. The reality is very different and, from a Chinese perspective, very much more worrying.

The only reason the Pilbara producers have moved product away from the spot market is that regional steel producers have stopped requesting deferrals of contracted shipments. Those requests, triggered by the collapse in steel demand through the December quarter of 2008, resulted in contracted tonnages being moved into the spot market. In other words, life has returned to normal for the Pilbara operators.

At the same time though, there is renewed pressure on the demand side of the equation with reports that Japan and Korea have re-entered the spot market. News that Nippon Steel plans to re-open one of two blast furnaces shut it shut in February as a result of collapsing steel demand, certainly supports a view that a recovery of sorts is under way. So do forecasts by Japan's Ministry of Economy, Trade and Industry that steel demand will rise by 12 per cent over the July-September quarter and that crude steel output will increase by 14 per cent.

The other point to appreciate here is that China is currently paying a provisional price for the iron ore delivered under its long-term contracts with Rio Tinto and BHP Billiton. It has been presumed by many (me included) that this price was effectively a derivative of the formal benchmark price. But that is not the case. The price is, rather, a construct of the benchmark, the spot price and forward prices. Which means China is currently working to the beat of the sort of index pricing regime which BHP Billiton has been pursuing for so long.

The humiliating result for China then is that it is paying more for contract deliveries of iron ore than it would have paid if it had signed on the dotted line back in early June. That means it is paying more than its competitors in Japan, Taiwan and Korea and that neither Rio Tinto nor BHP Billiton would be much motivated to actually reach a price settlement with CISA any time soon.

So how long is the stand-off sustainable then?

Well, the idea that there might not actually be a 2009 benchmark settlement with China was canvassed very discreetly on Monday by Fortescue Metals during a briefing on its strong quarterly production performance. No one in the Big Two is prepared to openly canvass that sort of outcome, but the word is that the long-term contracts would remain enforceable without a settlement and that, anyway, the incipient (if still uncertain) recovery of demand in China, Japan and Korea particular meant both could expect to continue to sell all the ore they can mine.

o the immediate downside risk of not setting a price, from the producers' perspective at least, would seem to be relatively low.

That doesn't, needless to say, help poor Stern Hu or his three colleagues, whose shared fate right now looks dismal indeed.

The Australian's authoritative Asia-Pacific Editor, Rowan Callick, reckons Hu might not see a Chinese courtroom for another year and that, barring a guilty plea, his fate might be maybe two years in the sealing. The prospect of a successful diplomatic interruption to this gloomy process is very, very small, according to the experts.

Which is why, I reckon, the Prime Minister deserves some considerable praise for the relatively uncharacteristic bluntness of the warning he delivered to China yesterday. Some may be more ambivalent about the timing and content of Rudd's spray. But, on balance, I think the timing and the tone is right.

"But I will also remind our Chinese friends that China too has significant economic interests at stake in its relationship with Australia and with its other commercial partners around the world," Mr Rudd told an audience of reporters in Sydney.

"A range of foreign governments and corporations will be watching this case with interest and be watching it very closely and they will be drawing their own conclusions as to how it is conducted. It is in all of our interests to have this matter resolved."