Planned BHP Billiton/Rio Tinto Iron Ore JV
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Planned BHP Billiton/Rio Tinto Western Australian iron ore JV The customers’ perspective ACE conference 2011 Bergen, Norway Background and introduction Background to the case ● Proposed Western Australian iron ore production joint venture between BHP Billiton (BHPB) and Rio Tinto (RT) was announced in June 2009. ● Followed the abandoned acquisition of RT by BHPB in 2008. ● JV plans ultimately abandoned in 2010, following concerns raised by competition authorities in various countries. Frontier Economics’ involvement in the case ● Frontier Economics were advising five Japanese steel mills, who were customers of the parties and opposing the planned JV, during the proceedings before the European Commission and the German Federal Cartel Office. ● Information available to us about the planned structure and working of the JV was largely limited to information in the public domain, including the planned “Core Principles” of the JV. 2 Frontier Economics Two issues considered in this presentation Was the joint venture really different from a merger in terms of potential competitive effects? Would the parties have had an incentive to withhold output/capacity and what role did synergies play? 3 Frontier Economics ● Concerns raised by the structure of the JV ● Incentive to withhold and the role of synergies 4 Frontier Economics The parties argued that the structure of the JV would not raise competition concerns… BHPB RT JV would be limited to the production level and Production Production operate as a cost centre. BHPB RT Marketing arms would remain separate and request Marketing Marketing output from the production JV independently. Steel mills 5 Frontier Economics …but competitive effects could still arise under the envisaged structure 1 Risk that the production JV has the ability and incentive to restrict supply even if it acts independently from the marketing arms: Ability – depends on reactions of customers and rivals Will come back to Incentive – unless wholesale prices are strictly set as “cost-plus”, this later they will depend on the supply/demand balance 2 Risk that BHPB and RT could influence production decisions through non-executive Owners’ Council 3 Risk of coordination between marketing arms due to increased transparency 6 Frontier Economics Two clauses in the term sheet could potentially have reduced the competition risks ● “The Manager [of the production JV] will present an annual budget designed to optimise the capacity from existing Short-run operations (including presenting options for improvements).” (Clause 4.1) But unclear what “optimise capacity” means and how Manager would be incentivised. ● “If only one Owner wants to proceed with the expansion on a sole risk basis, then the expansion will be undertaken by the Long-run Manager with that Owner paying all costs (including all capex and fully allocated operating costs).” (Clause 6.6) Idea behind sole-expansion: if the JV attempts to limit expansions to the monopoly level, BHPB and RT would have an incentive to sole-expand to restore the duopoly level of expansion. 7 Frontier Economics The term sheet contained various clauses that could have limited the likelihood of sole risk expansions 1 “To sole risk an expansion, the capital expenditure for the project must be greater than US$250 million”. 2 “The expanding Owner will compensate the other Owner, at market value, for its share of the underlying in-situ resource, as determined by an independent expert.” 3 “Where the expansion will use existing infrastructure capacity, the JV will charge the sole risking Owner for that capacity on the basis of principles to be agreed in the binding agreements.” 4 “All new or potential iron ore acquisitions or investment proposals in WA must be put to the JV by an Owner or the CEO for its assessment.” This means the JV has a right-of- first-refusal! 8 Frontier Economics The problem with the right-of-first-refusal RT proposes a sole-expansion to compete with the JV. BHPB knows its profits will be lower if expansion proceeds outside the JV than inside the JV because of business stealing. BHPB insists that expansion should proceed inside the JV. Commercial incentive to expand – business stealing from the JV – is eliminated. Foreseeing this outcome, RT would not propose sole-expansion to compete with the JV in the first place. 9 Frontier Economics ● Concerns raised by the structure of the JV ● Incentive to withhold and the role of synergies 10 Frontier Economics Incentive to withhold depends on the likely supply response of other miners Unlikely that competitors would undermine output or 120 Vale capacity withholding of BHP Billiton BHPB and RT. Rio Tinto Other 100 Other Miners BHPB BHPB and RT are closest competitors (large low-cost 80 high-quality mines and reserves located in Western 60 Australia). Other Rio BHPB No significant spare capacity BHPB held by smaller miners in the 40 Rio BHPB short run, reserves smaller Vale and of lower quality. Vale Shortrun marginal cost (US cents/dmtu) 20 Vale Vale, the remaining large miner, would not have 0 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 incentive to fully “fill the gap”, given large sales base and Fines production (million dmtu) infra-marginal mines. Source: Independent Iron Ore Industry Analyst. 11 Frontier Economics Parties claimed USD10 billion of synergies, but customers were doubtful that these would materialise 1 Direct pass-on of synergies to customers unlikely since parties’ mines are infra- marginal. 2 Indirect pass-on depends on incentive to increase output, but this was unclear. Not sufficient visibility on how much of the synergies would have been savings in variable costs. Yandi area 3 Customers were also concerned that a) many synergies involved delay/cancellation of capacity expansion projects compared to the counterfactual (e.g. in relation to port capacity), and Source: Google Earth. b) the JV was not indispensable to achieving most synergies (except for Yandi mines). 12 Frontier Economics Concluding remarks Was the JV really different from a merger in terms of potential competitive effects? ● Despite not being a full-blown merger, the JV raised a range of competition concerns due to its planned structure. ● Specific clauses that could have mitigated these concerns would most likely not have been sufficient to prevent withholding of output and/or capacity post-JV. Would the parties have had an incentive to withhold output/capacity and what role did synergies play? ● We were not able to quantify this with absolute confidence due to data limitations, but there were strong indications that BHPB and RT would have had the ability and incentive to withhold output and capacity post-JV. ● The parties pointed to significant synergies to offset this incentive, but customers were doubtful that synergies would be sufficiently large and of the required type to eliminate their concerns. 13 Frontier Economics Frontier Economics Limited in Europe is a member of the Frontier Economics network, which consists of separate companies based in Europe (Brussels, Cologne, London and Madrid) and Australia (Melbourne & Sydney). The companies are independently owned, and legal commitments entered into by any one company do not impose any obligations on other companies in the network. All views expressed in this document are the views of Frontier Economics Limited. 14 Frontier Economics FRONTIER ECONOMICS EUROPE LTD. BRUSSELS | COLOGNE | LONDON | MADRID Frontier Economics Ltd, 71 High Holborn, London, WC1V 6DA Tel. +44 (0)20 7031 7000 Fax. +44 (0)20 7031 7001 www.frontier-economics.com 15 Frontier Economics .