Just months ago, BHP Billiton Ltd. (ADR: BHP), Rio Tinto PLC (ADR: RTP) and Brazil”s Vale (ADR: RIO) negotiated an 86% price increase in the benchmark price of iron ore as demand for steel boomed.

“Iron ore prices should keep pace with steel prices which have fallen to the 1994 level,” Shan Shanghua, secretary in general of the China Iron and Steel Association, told Bloomberg in a phone interview. “We are asking for a big drop in iron ore prices.”

Vale, the world”s largest iron ore producer set the stage for contract negotiations earlier this year when it secured a 70% increase in the benchmark price of its ore. BHP and Rio upped the ante by using their proximity to Asia as leverage to demand benchmark price increases that ranged from 80% to 97%. The average increase in benchmark iron ore prices paid by Chinese steelmakers was 86%.

Steel demand, output, and prices have declined substantially since then, returning some leverage back to consumers.

The benchmark price, established in April, is paid only on material that meets certain specifications listed in the contract. Other material is sold at a discount to the contract price. Of course, considering the slump in steel demand that has accompanied the global economic downturn, it”s unlikely that BHP, Rio or Vale are getting anything close to their negotiated benchmark prices of about $100 per metric ton.

“It”s the reality that current contracts cannot be fulfilled,” Shan said. “Many bigger mills don”t need to import till the end of March, some even the end of May.”

But Chinese steelmakers still aren”t satisfied, and the government wants to take advantage of the opportunity to haggle down the exorbitant prices that producers squeezed out of Beijing last spring.

If Shan is serious about iron ore prices tracking those of steel, China will demand an 82% reduction in iron ore costs, according to Bloomberg. Benchmark contract iron ore fines sold by Rio Tinto, for instance, currently cost around $92.58 a metric ton. However, a return to the levels seen in 1994 would reduce that same iron to a cost of just $16.685 per metric ton.

China also wants the new contract prices to go into effect Jan. 1, 2009, rather than April.

Of course, few analysts believe that China”s demands will be met – regardless of the tepid outlook for steel demand over the next year – and that this is more likely just a case of China giving the ore producers a taste of their own medicine by playing hardball.

“It”s going to be a difficult price negotiation as miners and mills are divided in the market outlook,” Helen Lau, a Shanghai-based analyst with Daiwa Securities Group Inc. told Bloomberg. “But iron ore prices are determined by demand, not steel prices. The association”s comment is part of negotiating tactics.”

Source: China Plays Hardball with Iron Ore Producers, Seeking 82% Reduction in Price