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Who’s afraid of an iron ore inquiry?

By Michael Potter - posted Thursday, 21 May 2015


It looks likely that there will be an inquiry into the iron ore industry. The inquiry will probably look into accusations from Mr Andrew ‘Twiggy’ Forrest (of Fortescue Metals) that the iron ore majors, BHP and Rio Tinto, have harmed Australia by expanding supply and driving down the price of iron ore, and explore suggestions from Mr Forrest that ore producers should instead restrict supply to restore prices to previously high levels. BHP and Rio have rejected the need for such an inquiry. But they should not be afraid of the opportunities an inquiry will present to clear the air.

An inquiry would particularly enable an examination of the obvious contradiction in Mr Forrest’s arguments. He is accusing BHP and Rio of collusion to drive down prices; and his solution to this is collusion to drive up prices. He opposes collusion that harms Fortescue, and supports collusion when it benefits Fortescue. What a surprise.

Any inquiry would also examine whether Rio and BHP deliberately driving down prices (or even colluding). It is true that Rio and BHP have expanded production, and this has caused prices to fall to some extent. And a number of Australian and foreign producers are uncompetitive at these prices.

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However, an inquiry would need to delve deep into the issue as there is no public evidence that Rio and BHP have colluded, and the ACCC has so far found no evidence either. Rio and BHP’s actions appear rational: they have capacity to expand, so why wouldn’t they increase production if they make a positive margin (ie their prices are still above costs)? Rio has also argued that if they don’t increase their production then someone else will.

Another possibility has been raised: Rio and BHP are trying to drive other producers out of business, and once they have captured the market, then ramp up prices (this is typically known as predatory pricing). However, it wouldn’t be particularly difficult for production to be re-started at mothballed mines if prices get too high. So the potential for Rio and BHP to engage in predatory pricing appears very limited at best. In addition, Rio and BHP can’t be singled out for predatory behaviour: many other producers have been increasing their production (including Fortescue!). But an inquiry appears to be the best way to examine this accusation.

How about the idea of a cartel to cut ore production and increase prices?

If Australian miners operated alone to cut their production, then overseas production could expand to fill the gap. It would just be a free kick to Brazil in particular. So any cartel agreement will need to include other major exporting countries such as Brazil. An iron ore version of OPEC, if you will (although OIOEC doesn’t have much of a ring to it!).

Superficially, there are arguments in favour of establishing such a cartel. The higher prices would make Australia as a whole better off: we would receive more for our largest export; tax revenues will rise; and the dollar will probably rise too, making Australian households better off (because imports will be cheaper). The benefits of a cartel would be magnified because the demand for iron ore is fairly unresponsive to price (technically, demand is price inelastic).

But there are plenty of downsides to an iron ore cartel. It will damage our arguments against other production cartels (like OPEC) and harm Australia’s international efforts at collaboration in other unrelated areas. All net consumers of iron ore will be quite annoyed at us, particularly China, and retaliatory action could not be ruled out.  In short, Australia’s global reputation would be trashed.

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There is also the problem of maintaining a cartel. There are always strong incentives for members of a cartel to ‘cheat’ and expand production. OPEC has faced this issue, as would any iron ore cartel.

In addition, the cartel will harm all other trade exposed businesses in Australia such as farmers, manufacturers and miners of other commodities, because the dollar will be higher. Businesses that use iron ore will be particularly hard hit. However, this argument shouldn’t be overstated: at least in theory, the government could tax the gains of the winners and distribute it to the losers so that all Australians are better off.

The largest beneficiaries of a cartel will be the shareholders of BHP and Rio, but they have significant foreign ownership, diluting the argument that Australia as a whole will benefit from a cartel. It should also be noted that BHP and Rio appear to oppose a cartel, suggesting the benefits to BHP and Rio are smaller, or downsides are larger, than first appears.

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About the Author

Michael Potter is an economist and public policy commentator and authored the papers Fix it or Fail: Why we must cut company tax now and The looming crisis in business investment for the Centre for Independent Studies.

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