Commodities

Imposing price caps on commodities like oil and iron ore is a risky business

Beijing will be keeping a close watch on the G7’s efforts to cap the price of Russian oil because China is trying to do the same to Australian iron ore.

As the world’s biggest exporter of resources and energy, Australia has a vital interest in transparent and freely negotiated commodity markets. Its economy would be seriously jeopardised if consumers were successful in using their combined power to supress prices for specific commodities.

China accounts for 70% of global imports of iron ore and has long believed that its dominance of the market should give it greater influence over prices. The China Iron and Steel Association plans to have a central iron ore buying agency in place by the end of the year to stop individual steel mills from bidding up prices against each other.

The G7 plan would exploit the US’s and UK’s control of financial services to the shipping industry, particularly insurance, to prevent Russian oil from being loaded on tankers if its price exceeded a G7-imposed limit. Although the G7 accounts for only 30% of global oil imports, virtually all shipping insurance goes through the London markets.

Insurers would be forbidden from providing coverage for ships taking on Russian oil at higher prices. Two-thirds of Russian oil is shipped in tankers owned by companies based in the European Union, the UK or Norway, which increases the G7’s leverage.

The idea is that the price cap on Russian oil would apply not only to the oil purchases of G7 nations but to all Russian oil exports.

The G7 ambition is to stop Russia from profiteering from the energy crisis that has been partly precipitated by its war on Ukraine. ‘We are working to make sure Russia does not exploit its position as an energy producer to profit from its aggression at the expense of vulnerable countries,’ the G7 communiqué said.

The volume of Russia’s oil, gas and coal exports in the first three months of the war was down 15% from the same time last year, reflecting the impact of sanctions, but the average revenue is up by 60%, even after taking into account the discounts that Russian oil is suffering in world markets, according to analysis from a Finnish think tank.

Russian oil has been selling at about a 30% discount to the Brent benchmark (based on the price for North Sea oils) to compensate for the difficulty in obtaining trade finance for dealing with Russia.

Japanese Prime Minister Fumio Kishida indicated that a much steeper discount was envisaged in the G7 plan, commenting that the price cap would be ‘about half’ the current market price of around US$100 a barrel.

The big risk in the G7 plan is that rather than accept the imposition of a 50% price cut by Russia’s adversaries, Russian President Vladimir Putin would order a halt to the country’s oil exports to anyone demanding sub-market prices.

Russia accounts for around 8% of oil supplies to the global market. Its former president Dmitry Medvedev recently warned that the G7 plan could take global prices well above US$300 to US$400 a barrel.

That is hyperbole, but former International Monetary Fund chief economist Olivier Blanchard has estimated that the removal of just 3% of world oil supplies could result in a 30% price increase.

There would also be a risk that other big consumers of Russian oil like China and India would arrange their own insurance and shipping to keep their Russian oil flowing. The more oil Russia could sell outside the G7 blockade, the easier it would be for it to cut sales to the West.

The defining feature of commodities is their fungibility—they are the same wherever they are produced and, as a result, they fetch the same price, barring market interference.

Oil is the world’s biggest commodity market, with annual international trade of about US$1 trillion, or about four times the size of next-ranked iron ore. With vast numbers of sellers and buyers, it would be difficult to hermetically seal Russia’s 8% market share.

Even against the relatively small producers Iran and Venezuela, former US president Donald Trump’s ‘maximum pressure’ campaign of sanctions had only partial success. Oil sales were reduced but not eliminated because work-arounds were developed.

The idea of a G7 price cap was first mooted by US Treasury Secretary Janet Yellen in February. Last month’s G7 summit agreed to ‘explore’ the concept; however, German Chancellor Olaf Scholz commented afterwards that the concept was ‘very ambitious’ and would ‘need a lot of work’ to become a reality.

The danger is that a buyers’ cartel would prove no more effective than the OPEC producers’ cartel was in the 1970s. While OPEC engineered a short-lived price spike, within a decade its share of the world oil market had dropped from 51% to 30%.

One might imagine that fixing the price of iron ore would be a lot simpler in China’s centrally planned and authoritarian economy. Yet, a concerted effort to impose a buyers’ cartel failed in 2009. When price negotiations became deadlocked, the China Iron and Steel Association ordered a complete boycott of Australian iron ore. However, smaller mills—fearful for the security of their supply—ignored the order, which ultimately led to the collapse of negotiated iron ore prices.

A recent Australian Financial Review report, which appeared to reflect the thinking of the iron ore majors, commented that rumours of a central buying group had been around for a decade without coming to anything. One of the problems is that China has hundreds of steel mills. Small mills would be concerned that a central buying group would favour the large state-owned steel mills.

China’s demand for steel is volatile, depending on political decisions on infrastructure and other stimulus programs, as well as on the vagaries of the property sector. Central planners frequently get their forecasts of demand wrong, so both large and small mills would be left sweating on the accuracy of the central buying group’s orders.

All consumers want lower prices, but it’s ultimately the genius of transparent markets that they deliver a price that matches both supply and demand. The suppression of a price through consumer power (known as ‘monopsony’) ultimately leads to lower investment, lower production and higher prices. In the same way, the artificial boosting of a price through a producer monopoly would lead to a search for substitutes and a long-lasting destruction of demand.

The chances of either the G7 engineering a special discounted price for Russian oil or China manipulating the price of Australian iron ore are not high. However, with resources and energy accounting for almost two-thirds of Australia’s exports, the new resources minister, Madeleine King, should be paying close attention to their efforts.

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