The global wise men of asset prices and capital flows have weighed in on Aussie house prices. They have been found overvalued. Crikey. Hey, you can’t say we’re being knee-jerk bears on this one. “Australian property is among the most overvalued in the developed world and the risk of a correction in house prices is high by international standards,” reports Adrian Rollins in today’s Financial Review.

–Where did the gains come from, the IMF wants to know? Was it a boom? Was it a bubble? Did they come in through the bathroom window?

–”The IMF warns that about 25 per cent of the increase in house prices between 1997 and 2007 cannot be explained by fundamental economic factors such as income and population growth,” Rollins reports. Like in America, housing affects the equity market because of the central role rising house prices play in consumer finances. It’s the wealth effect from property.

–”The IMF says households are relying more on rising house prices to get access to credit and fund spending, making them much more sensitive to changes in property values-a shift with significant implications for monetary policy.”

–In other words, if the RBA raises the cash rate on May 6th (in response to persistent inflation), and the banks anticipate that rise by raising THEIR rates first, then consumers are going to be in for a very bad winter in Australia.

–If consumers can’t tap their homes (or incomes) to finance consumption, they either turn to credit (as they have in the UK in record numbers in the first quarter) or they do something even more drastic: they slow down consumption. You reckon that would be bad news for Harvey Norman and David Jones?

–About the only good news from the IMF study on Aussie house prices is that it is not as bad here as it is in other places. Ireland, the Netherlands, and Britain all rank ahead of Australia in terms of the their vulnerability to a drop in home values. So we’ve got that going for us.

–From one pillar of the Australian dream (housing) to the other pillar of this historically good economic run: iron ore. Gold and coal are the other big export earners for Australian resource firms. But iron ore is, in many ways, at the rusty red heart of the boom, not least because it’s so key to the earnings growth of Australia’s two big miners, BHP Billiton and Rio Tinto.

–Yet here we are, three full days after the new annual contract price is normally settled between Aussie miners and Chinese steel markers… and still no contract price for 2008. It isn’t a stalemate. But in chess, surely this would be the end game, where hostilities have to be initiated, strategies executed, and glorious victory secured. Let’s review what’s happened so far this year.

–On February 1st 2008, the Aluminum Corporation of China (Chinalco) joined forces with Alcoa in an overnight raid on the London exchange. The companies paid $14 billion to buy 14% of Rio’s London-listed shares, giving them a 9% stake in Rio’s Australia listing. That stake has been called a “blocking stake” here in Australia because it’s believed China is trying to block the merger of Rio Tinto with BHP Billiton-a merger that turns Australia into the Saudi Arabia of iron ore, with huge pricing power of Chinese steel producers (you can see why China wants to block the deal).

–On March 13th, 2008, Chinese metals behemoth Sinosteel made the first ever hostile bid for an Australian company. The target? Midwest, an iron ore junior south of the Pilbara region in Western Australia. Sinosteel offered $897 million. It is the first-but surely not the last-Chinese bid for a publicly listed Australian company with the valuable mineral and metal assets China seeks to secure for its long-rate strategic economic plan.

–On April 2nd, Australia’s Takeovers Panel, citing “unacceptable circumstances” blocked an attempted takeover of Mt. Gibson Iron ore by Chinese-backed steel maker Shougang. The panel said Shougang already owned a sizable position in Mount Gibson due to its stake in Hong Kong-based APAC Resources Ltd. which owns 20.2% of Mount Gibson’s shares. Under Australian law, a shareholder must make a formal takeover bid once it acquires more than 19.9% of a target’s shares.

– The Australian miners want the same price hike Brazilian giant Vale extracted from Nippon Steel in Japan and Posco in Korea (a increase between 65% and 71% over last year’s contract price. The Chinese are-represented by Baosteel-are unwilling to budge. Vale got a big increase because the cost of shipping the ore to China from Brazil is about $67 a ton. Because it’s a lot closer, it only costs the Chinese about $23 a ton to ship ore back to the mills in China.

–Australian producers want what they’re calling for a “freight premium.” And they seem more than willing to wait for it. In the meantime, Rio Tinto has exercised an obscure provision in its contract with Chinese steel mills to sell ore into the spot market, where the price is getting on US$200. If no agreement is reached between Chinese mills and Aussie miners by June 30th, the Aussie miners are free to sell ore into the spot market.

–Australia’s miners seem to be taking it for granted that the Chinese mills will buy from them even at higher prices, because, well, that’s what they’ve always done.

–But it’s worth considering the possibility, however remote, that China is truly offended at the negotiating strategy of BHP and Rio and is serious about getting its ore elsewhere. “If Australia succeeds in getting a freight premium and the price of Australian ore increase a lot,” says Chen Xianwen, the deputy director of the China Iron and Steel Association, “this would mean that Australian ore is not as competitive as Brazilian iron ore.”

–Chen also told the Financial Review that, “Australia accounts for 40% of China’s iron-ore imports. But if Australian ore is not as competitive, steel mills won’t buy from Australia. This will be a heavy loss for Australia. The world economy will slow down this year and China steel production will slow down. If Australia cannot sell their iron ore into China, where will their iron ore go?”

–The Chinese steel makers claim they can’t sustain another big increase in ore prices and still remain profitable. The Aussie miners obviously reckon the Chinese can pay much higher prices and still absorb them comfortably. Besides, it is not good business policy to extort profits from your clients merely because you have a strong position.

–All in all, the strategic game for Australia’s mineral assets is unfolding right before our eyes. We reckon there are two possibilities. Australia could stuff it all up by ruining the relationship that is at the heart of the boom. That would be consistent with Bill’s ironic philosophy that people and institutions have to find a way to destroy themselves and squander their good fortune.

–However, it’s a lot more likely that the Chinese mills and the Aussie miners will come to some sort of agreement before June 30th and that iron ore prices will go up. This makes all of Australia’s economically demonstrated reserves of iron ore much more likely to be developed… and opens the door for the junior producers in the Pilbara and Midwest to cash in on the boom.

–Does Australia have an energy security policy? If it didn’t, it would be alone. America doesn’t seem to have one either. Caltex director Des King told investors yesterday that Australia would import 50% to 70% of its refined fuels by 2030. “This is a huge energy security risk,” he added.

–The trouble is that the Australian refinery industry is not competitive with refineries being built in Asia, King said in today’s Australian. For example, Reliance Industries in India is currently building a single refinery with a capacity of 600,000 barrels per day-greater than the combined capacity of Australia’s seven operating refineries (590,000 bpd).

–Refined fuels, mind you are different than crude oil. An industrial economy needs all manner of specialty petroleum products to keep the wheels of commerce from squeaking. It’s not just petrol for transportation fuel and kerosene for jet fuel.

–But demand in Australia for refined fuel products is growing faster than the current refineries can keep up with, forcing Australia to import more from refineries in Asia (especially Singapore). Australia’s seven operating refineries are listed below in a chart from a 2004 report prepared by the Howard Government called “Securing Australia’s Energy Future.”

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