Japanese steel mills face coal pricing challenge

STEEL mills will have to adapt to new shorter-term raw material pricing mechanisms or stick with the existing custom of selling their products at annually fixed prices and risk seeing margins erode if input prices rise.

JFE Holdings Inc, the world's sixth-biggest steelmaker, said on Friday it had agreed to a price rise of 55 per cent for April-June supply of hard coking coal from Australian mining giant BHP, but will seek an annual contract again when the deal expires in July. The steelmakers, including world No 2, Nippon Steel Corp, have resisted BHP's move over conflicts with their sales practices to key customers such as automakers.

But the mills, which sell much of their steel to carmakers on an annual basis and would feel exposed if the price they paid for raw materials was reviewed quarterly, will probably have to cave in to BHP due to its influence over the supply of coal, analysts in Japan and Australia said.

With the chance of an annual contract in July looking increasingly remote, Japanese steelmakers are facing a tough choice: change the way they sell their products to customers or gamble their profits on setting annual steel prices.

Some analysts say a shift to a shorter contract could hurt their profits in the next financial year starting April 2010. "There's been a sea change in Asia's coking coal market as China has emerged as a new buyer, boosting spot trade volume and prices," said Toru Nagai, managing director at independent research firm Advanced Research Japan.

"Even Japan's manufacturing sector, which has long benefited from stable supplies and costs of raw materials under the annual benchmark system, can't escape from the changes unscathed."

BHP, the world's largest diversified miner, said the quarterly contract, based on market based pricing, reflected its efforts to move to market-clearing prices over time across all bulk commodities.

Japan's steelmakers have four main options to deal with the new world of flexible pricing:

Steelmills and their customers could sit down each quarter once coking coal prices have been set to renegotiate product prices. Analysts said this was a simple solution but talks take time and it would be unpopular with consumers.

"It will be annoying for the industry to change prices quarterly but the steelmils otherwise risk being squeezed by higher raw material prices," said John Meyer, a London-based analyst at Fairfax.

"The end-consumer - the guys who buy the steel are interested in fixed price contracts. Would you order a car knowing the final price will vary depending on the cost of steel, plastics and rubber?"

Mills would still have a hard time passing on higher costs to consumers in quarterly talks, Nagai of Advanced Research said. Steelmills could stick to the existing system of pricing products annually, but that injects a huge amount of uncertainty into the market. If raw material prices increase dramatically steelmakers may find themselves facing huge losses.

Meyer said the deal suggested coke consumers were expecting a shortage of the material with the potential for prices to rise across the market. That in turn would force up costs for steelmakers buying on the spot market, in particular China, driving up prices for steel. That could offer some margin safety but other analysts saw it as a very risky proposition.

"This creates huge margin risk," said Andrew Harrington, coal analyst at Patterson Securities. Steel-makers and their clients could adopt a surcharge system similar to that in the stainless steel industry, where changes in average nickel prices are used to calculate a surcharge or discount for stainless steel buyers.

In the case of coking coal, the change could be based on the quarterly negotiated settlement between miner and mill. However, Japanese steel consumers may not embrace the idea, worried that BHP, which dominates Japan's coking coal imports, might find it easier to push through price hikes if the entire increase in coke prices is passed straight to consumers.

Takashi Murata, analyst at Daiwa Securities Capital Markets Co said Japanese mills wouldn't move into a surcharge system.

"They will lose their competitive edge as a maker of tailor-made, super high-end steel, if they move into an automatic pricing mechanism. (Instead), they'd do everything - like big mills will get together, streamline their products and boost value. As users like carmakers can buy high-grade steel of their specifications only from Japanese mills, they'll have to accept price hikes anyway."Reuters