The China Plan for Purchases

China has adopted an interesting plan to reduce the rate of cost it pays for the metals and ores it purchases.

China is a big consumer of stainless steel. It needs nickel to produce this stainless steel. While it has some mines of its own, it needs to import nearly a quarter of its total needs. To fill part of these needs and to give itself some leverage against the largest suppliers of nickel, China has begun forming alliances with the smaller nickel companies. In some cases, China has made an investment in the smaller miner. In other cases, China has guaranteed to take a certain amount of these miners’ production at a fixed price. These alliances have helped the small miners avoid the worst of the repercussions of limited availability of credit in the current economy.

China is trying something similar in the iron ore market. The top three iron ore producers, Rio Tinto, BHP Billiton and Vale control about 70% of the iron ore transported by sea. China has been unable to break the unified pricing approach of these big three suppliers, so it went around them. Recently, it made an agreement with a small iron ore producer, Fortescue Metals, to purchase iron ore at a 3% discount to the international price being charged by the big three. In return, Fortescue will get up to $6 billion in financing from the Chinese to put to the expansion of its business (See Video #40: Price Shaver on StrategyStreet.com).

In both these arrangements, China is trying to make a small supplier a lever against a very large supplier to drive down the price. This usually does not work, for two reasons. The first is performance. A smaller suppler simply can not provide for most of the needs of a Very Large customer, such as China. Small suppliers usually can compete only in a limited geographic market and with a limited product range. The second reason is one of cost. Commodity markets are extremely competitive. Scale counts for a lot. Economies of scale rule! (See Audio Tip #195: Economies of Scale and Their Measurement on StrategyStreet.com) The smaller competitors will not have the same economies of scale as the larger competitors. The discounts that the smaller competitor must give up in order to secure the business of the Very Large customer more often than not serve to weaken the ability of the smaller competitor to perform to the same level as the largest competitors in the market.

I think China will find that if it wants to break the strangle hold of the largest suppliers in the market place, it will have to convince one of the largest suppliers, rather than one of the smallest, to discount for it.