Rio's Iron Ore Race Costlier
than Marlboro Friday

Issue 118, March 2015

On April 2nd 1993, tobacco manufacturer Philip Morris cut 40 cents off the price of its cigarettes in the US, a drop of 20 per cent.

Known as Marlboro Friday, the news wiped $2bn off Philip Morris’ profit and $13bn off its market cap. “Rarely has a single, simple statement destroyed so much wealth in so little time,” wrote Fortune magazine.

In any other industry, the volume race being led by Rio, Vale and BHP would be seen as a price war, mutually destructive and a red flag to generalist investors. But because miners are price-takers, it is thought to be rational to focus purely on maximising tonnage.

On the contrary, it is not. With Rio, Vale and BHP commanding 60 per cent of seaborne iron ore, their volume decisions determine the price and the price they have determined is lower. For maths theorists, it is textbook Cournot theory, ending in a U-turn.

Volume added $1.4bn to Rio’s profit in 2014, offset by a $4bn fall in pricing, bigger than the wealth destruction on Marlboro Friday. With iron ore already sitting 30 per cent below last year’s average, this year’s damage looks set to be substantially larger.

Rio has the best capacity and the lowest costs, justifying its machismo as long as it remains cash flow positive, but the strategy fails to maximise its bottom line. “Regardless of what the price is,” Rio’s Sam Walsh has said, “we will be the last one standing.”

That too may be incorrect. On Tuesday, Glencore’s trading division reported its biggest profit since 2008, demonstrating how its business thrives in volatile markets and positioning it best to withstand the bout of price destruction engineered by peers.

Glencore is famously shy in detailing how its trading business, seen as a “black box” by investors, ekes out its margin, but the annual report of Trafigura, one of Glencore’s trading rivals, includes a giveaway line: “Trafigura is in one sense indifferent to price as we hedge our flat-price risk. But we are not indifferent to the benefits of falling prices for growth.”

INFOGRAPHIC: How Ivan Glasenberg's Glencore has outflanked peers 

“We are not indifferent to the benefits of falling prices for growth.”

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