Over the last few weeks the airwaves have been buzzing about the falling national income (and the problems for Mr Hockey’s budget) due to the rapid decline in the price of iron ore and Twiggy Forrest’s calls for restraint from BHP and RIO when it comes to delivering larger volumes of Australian iron ore into slowing international markets.

Unfortunately, the debate has lacked imagination and has tended to focus on two points,

• whether Mr Forester or any of the junior miners are “good blokes” or “good sheilas” and deserve ‘help’ or
• whether it is possible for any single Australian mining company /contractor to exert market power.

The later proposition has had all the ‘free market’ buffs out in force proclaiming that the market should be left to ‘sort out the problem’ as though the world is full of markets that are free and unmanipulated and thus the iron ore market should be left to run free………… like a Snowy Mountains brumby.

In all this static and distraction a fundamental point is being missed and that point is that at the present time and for some considerable period it is highly likely that AUSTRALIA will retain massive market power in the international iron ore market.

The bold capitalisation of Australia above is important because to date everyone is focused on the market power of individual mining companies/contractors rather than Australia who actually owns the iron ore.

While the Glass Pyramid has described in a number of recent posts, elements of the argument in support of and the solution to the iron ore ‘question’ from the perspective of the Australian national interest, there is some benefit in presenting the arguments and the solution again in a single post.

Our Iron Ore – Australia v Individual Mining Contractors

All the talk about whether any particular mining company has ‘market power’ in a market for a commodity like iron ore completely misses the point that Australia as a whole produces over 50% of the entire world production of iron ore and has almost no competition at the present time, apart from Brazil, for any of that volume when it comes to the cost of production.

This graph from the RBA makes the point clear – all that low cost production shaded yellow is Australian.

Certainly, in time other low cost producers of iron ore may (Reuters thinks it unlikely) enter the market but at the present time there is simply NO source of 700M tonnes of iron ore production available anywhere on the globe (including Brazil) that could replace the Australian production at anywhere near the Australian cost of production.  And that situation is unlikely to change any time soon – i.e. during the next 5-10 years.

The issue at the present time for Australia is simple.

Why on earth would we want our mining contractors competing against EACH OTHER when supplying the international market with OUR iron ore?

That makes about as much sense as Apple allowing all of its iPhone factories to independently sell direct to the public and compete between themselves and drive the price of iPhones to rock bottom.

Sure Apple has to compete against Samsung and other manufacturers but they sure don’t have to compete against themselves.

And that is exactly what Australia is allowing to happen with OUR iron ore.

We are allowing massive largely foreign owned mining contractors to come in and dig up OUR iron ore and then compete against each in the world market for market share and in doing so drive down the cost of OUR iron ore to rock bottom.

Sheer madness!

To deter new foreign suppliers entering the market all our mining companies need to do is undercut the new suppliers likely cost of production and because they can do that easily there will be few new foreign suppliers – without massive market manipulation by countries like China (yes sorry to break the news to those ‘free market’ ideologues but China does not hesitate to manipulate markets to achieve its big picture long term national economic objectives).

An Iron Ore – National Export Volume Auction as described below will allow Australia to respond appropriately to the kinds of mischief that China tries from time to time.

So what can Australia do to stop this sheer madness?

An Iron Ore National Export Volume Auction (Iron Ore – NEVA)

The solution to the problem of Australian miners competing against each other is straight forward.

Australia simply needs to set a nation cap on the volume of iron ore to be exported each year and require the mining companies/contractors working in Australia to bid for a slice of that export cap in a public auction.

That way the Australian Government can prevent the mining contractors/companies from competing against each other at OUR expense.

Every mining company that wants to export some volume of iron ore from Australia is free to do so provided they have bid for and secured an allotment for that volume.

No need to pick and choose between Twiggy, BHP, Rio or any of the other miners or ask people to voluntarily limit their volumes.  They can export as much as they like provided they have a licence for the volume they wish to export.   If Twiggy is determined to export 150M tonnes he can do so and all he has to do is bid enough at the auction.

How big should the Iron Ore National Export Volume Auction cap be?

Considering the international iron ore market is currently about 1.3 billion tonnes and Australia produced 720M tonnes in 2014, a national export volume cap set at 2014’s level of production (720M tonnes) or even a small increase on that (say 750M tonnes) would be a sensible starting point having regard to the decline in Chinese demand we are hearing so much about.

Set that 750M tonnes as the iron ore National Export Volume Auction cap per annum for say the next 5 years.

So the proposal is nothing more than to maintain national iron ore export volumes at the 2014 levels for the next 5 years.  Not exactly a radical suggestion when all we hear about is declining demand from China.

How would the auction work?

The auction would be very simple and would consist of 7500 auction lots for each of the 5 years of the period of the cap.  Each lot would be for a licence to export 100,000 tonnes of iron ore.  

7500 lots each consisting of a permit to export 100,000 tonnes equals a total of 750M tonnes iron ore exports. So the initial auction for export volume licences for the first 5 years would involve 37,500 lots.

They could televise the Iron Ore National Export Volume Auction after renovation rumble with some attractive hosts or some boofy blokes in Hi-Vis vests.  Like an RSL chook raffle with some serious cash involved. Imagine the public interest as they see Gina and Twiggy jumping up and down with their bidder paddles as they try to out bid the big boys BHP and RIO for export volume licences.

Joe Hockey could stand next to the cash box and cry “Come on down” to each successful bidder.

Let the major and the junior miners duke it out for the licences to export OUR iron ore.

They are big, smart and ugly enough to cope with the business decision of calculating how much to bid for those licences.  They will need to think about the international market, potential competition from foreign producers – new and old, demand from customers like China, Japan and Korea etc.   Sure there is some risk involved but that will be reflected in the amounts they bid and as we know our mining company executives are the best in the world (or so they keep telling us).

Doing their sums and getting their bids right will be a walk in the park.

What would be the price bid?

No need for the government to try and set a price.  The auction room will do that.  The price bid by the miners will be somewhere between their cost of production and the price that non Australian iron producers can produce at.

The gap between the foreign producers sale price and Australian cost of production is the potential margin if Australian miners do not compete against themselves.  The auction is simply forcing the miners to bid for that currently very juicy margin.   Once they have bid for and paid for the licence they can still set whatever price they want when selling the ore into the international market place but any decision to undercut another Australian miner will now be at THEIR cost and not Australia’s.   

The following simple calculation makes the point.

Say an Australian miner can produce iron ore at $20 per tonne

Say a Lowest priced foreign miner produces at $50 per tonne

Australian miners who don’t compete against each other and only against foreign competition could sell their Australian ore at $50 per tonne and pocket $30 profit.    But if they compete against other Australian miners with the same $20 production cost the sale price might be competed down to $25 per tonne or even lower.  The effect is that Australian miners are selling well below the price ($50) that foreign producers can sell at only because they are competing against each other.

If there is a National Export Volume Auction cap the Australian miners will have to bid for the right to export a slice of the export cap.

As there is a potential profit margin of $30  ($50-20) and Twiggy, Gina, BHP, RIO etc are all excitedly bidding on national TV, the amounts bid for the export licences will be somewhere between $0 and $30. The amount will vary depending on how low each miner’s cost of production actually is and what they think they could sell the ore for on the international market.

If they fear that next year there will be 700M tonnes of foreign ore produced at lower cost than Oz ore entering the market they may bid only pennies or not bid at all (as they mothballs their mines) .  But if they calculate that it could be 5-10 years before there is any serious challenge to Australia as the lowest cost producer they are likely to bid significant amounts for the right to export and sell low cost Australian iron ore into the international market.

Having bid for and paid for the export volume licences they can be free to sell the ore they export at whatever price they want and compete against each other in doing so (for example below cost if they wish to win market share).    The important thing is that they will not be doing so at the expense of Australia.

If they get their sums wrong and don’t want to use any licences they bought they can sell them to another miner who wants to use them.

So even if the “free market” fairy stories are true and the iron ore market is like an endless supply of unicorns and Australia can only be a price taker the iron ore National Export Volume Auction will do no harm as the worst that will happen is that the miners will bid peanuts.

But keep in mind that at the moment there is little competition for Australian ore on price (other than Brazil) and almost NO competition in terms of volume at the low cost of production that Australia can deliver.

So forget the unicorn stories that the ‘free market’ simple folk keep warning you about.

What about the states and their royalty income?

The National Export Volume Auction will have no impact on states and their royalty income. They will remain free to collect royalty income as the existence of those royalties will be taken into account by the miners when bidding for a slice of the national export cap.

Further Auctions

Each year another year of export volumes ( 5 years hence) can be auctioned off. The government can decide whether the volume (750M tonnes) should be increased or reduced.    How many years are auctioned off is a matter for the government and they will aim for a balance between giving the miners some certainty for planning, the international demand for iron ore and the results of past auctions.

So is there a catch?

From customers

It is possible that some international buyers of iron ore (China) will whinge and complain that Australia is managing the supply of Australian iron ore into the international market by adopting a national export volume cap.  By stopping our mining contractors from driving the prices down to our low cost of production overseas buyers will pay more.

That argument makes about as much sense as telling Apple they must allow their iphone factories to undercut each other in the world market.

As we are already supplying over 50% of the world demand of 1.3B tonnes of iron ore, merely holding export volumes at 2014 levels (or even slightly higher say 750M tonnes), when Chinese demand is falling, is hardly unreasonable behaviour.

Especially when China imposes a bunch of export controls of various flavours to ensure that strategic resources like rare earth minerals and resources required for domestic manufacturing and industry remain available to domestic customers within China.

Every country has the right to manage the exploitation and export of its resources. Or to put it in terms that we are familiar with

“We have the right to determine what resources leave our country and the manner in which they leave”

From mining companies?

This is the real catch.  As you might imagine the mining companies (including Twiggy) will dislike this proposal for a National Iron Ore Export volume auction.

Understandably what they want to do is to collect as much of the margin between their cost of production and the price they obtain off shore.   That is why they tend to squeal about paying royalties, taxes or any payments to the owners of OUR iron ore.  That is nothing more than acting in the interests of their shareholders.

Being forced to bid and compete between for the right to export a slice of the iron ore National Export Volume Auction cap would be their worst nightmare as the more they bid the more the taxpayer receives.  Just in case they get any ideas about colluding in the auction to keep the prices down, allowing a few seats at the auction for non mining investors (who want to gamble on being able to resell some export licences) will keep the auction honest.

Needless to say when Twiggy raised the topic of an Inquiry and a few sensible folk argued that a wider inquiry was required that covered ideas like the iron ore National Export Volume Auction, there was a desperate campaign by all the other miners to shut the idea of an inquiry down as fast as possible.

Truly an opportunity lost!

No surprise that the usual gaggle of mining flunkies and “free market” myth obsessives and unicorn spotters completely ignore that it is OUR iron ore and whether an individual Australian mining company/contractor has market power in the world market is irrelevant to whether Australia can maximise national income from OUR iron ore.

But it is unfortunate that many commentators with normally little time for the squeals of miners pursuing super profits did not realise the opportunity the inquiry presented and shouted down the idea because it came from Twiggy and they figured that by definition ANY iron ore inquiry must be a bad idea.

We don’t need an Inquiry to introduce an iron ore National Export Volume Auction – just a bit of common sense and a few politicians who are prepared to argue for the national interest.

Update:   Reserve our Gas!

No doubt keen readers will have already wondered whether the National Export Volume Auction model could be applied to other Australian exports such as LPG.

As noted above the NEVA concept generally is only going to be useful when there is a real concern that Australia producers are competing against themselves to undercut foreign competition.

In most markets that is not the case as we usually have our hands full dealing with foreign competitors who undercut our cost of production by manipulating relative exchanges rates by exporting (with Mr Robb’s clueless assistance) vast amount of unproductive capital to Australia pursuant to the various FTAs that Australia has signed with unseemly haste over the last two decades.

Having said that if the objective is simply to reserve some volume of a resource (like LPG) for the domestic market the NEVA concept could be an effective way of both reserving the resource for the domestic market and achieving the highest possible return from those volumes of the resource which may be sold off shore.

For LPG could be achieved by setting a National Export Volume Auction cap for LPG exports and let the producers bid for a slice of the export cap.

LPG production sold into the local market would not be subject to any volume limits and thus any LPG producer who was out bid in the NEVA or chose not to bid would be free to sell gas into the domestic market.  By setting an appropriate Export Volume cap it should be possible to ensure that adequate supplies of gas are available to the local market. Naturally, there are limits as if too much gas is reserved to the local market such that the price is driven below the cost of production then producers will prefer to shut down production than supply the local market.    It should not be too difficult to avoid that problem arising.