As the mining boom has played a pivotal role in Australia’s current economic situation, it is not surprising that the majority of business headlines are dominated by information and debates about the mining industry particularly iron ore. Not too long ago you may have come across headlines about a state owned Chinese steel maker called Wuhan Iron & Steel corp. diversifying to pig farming. Perhaps a bit amusing at first until you realize the seriousness of the decision and the plausible rationals.
These Chinese steel producers are part of the chain that links our mining industry with the Chinese economy. Our miners first dig the iron ore and coking coal out of the ground and then sell it to the Chinese steel makers, who then sell the steel to end users such as construction and manufacturing industries in the Chinese economy. Apart from the slowing down in construction, steel is also piling up as inventory due to overproduction. Thus prices of steel have come down due to oversupply, and prices of iron ore come down too, as firms scale back on production. In fact prices of steel have fallen so dramatically that the average profit per tonne of steel is now 1.68 yuan (25c) compared to 118 yuan ($18.15) per tonne. In January, China’s 80 biggest steel mills collectively made a loss of 2.3 billion yuan ($350 million). Microeconomic theory tells us that quantities supplied by firms will drop and firms will exit from the industry until they break even. For the much larger firms which can weather the pain, they are looking for other places to put the cheap loans which are essentially forced onto them by state owned banks to work, such as real estate, telecommunications and manufacturing.
So then, why did Wuhan Iron & Steel make the decision to diversify to pig farming? Firstly, pork accounts for 70% of all meat products eaten in china. Pork is so widely consumed that it has shown a strong influence on inflation figures; hence the government has tried to control prices. The demand for pork in China has been robust and growing for decades even during swine flu/disease outbreaks (partly due to luck as it has not become an epidemic type issue). Production in 2012 is estimated to be 52.5 million tonnes compared to demand of 53 million tonne – pretty much equilibrium. As china is continually urbanizing, the demand is likely to increase due to a wealthier population. This creates a good opportunity for profit, as pork is essential to Chinese citizens’ daily diets, in other words demand is inelastic and there is limited downside to this strategy. Although there is the case of a potential glut that government intervention can cause just like in steel production, small family backyard producers which account for 30-40% of pig farming would take the brunt first. S. McOrist, K. Khampee & A. Guo (2011) estimated the cost of production is approximately 7-12 yuan per kilo, compared to selling pork for 26 yuan a kilo, a fairly good return compared to steel’s 25 cents per tonne.
Although I have not made comparisons on the returns of other diversification ideas that other steel makers have undertaken, such as telecommunications, real estate, utilities etc. My point is that this decision is not as silly as it seems. Wuhan Iron & Steel views raising pigs as stable stream of profitable income due to the idea that pork consumption has been and will always be around. As the profits from steel activities in china are crumpling, non–steel activity is now accounting for almost half, and in some cases more, of steel maker’s profits. Raising pigs is only part of Wuhan Iron & steel’s 39 billion yuan investments in non-steel activities which keeps the company afloat, and likewise throughout the steel industry it allows these companies to continually follow the orders of the Chinese government to continue overproducing steel. If one day, Marius Kloppers of BHP came out stating they are now exporting pigs to china, the whole country would think his gone mad, but I wouldn’t be surprised at all.
Reference: S. McOrist, K. Khampee & A. Guo (2011) Modern pig farming in the People’s Republic
of China: growth and veterinary challenges. http://www.oie.int/doc/ged/D11362.PDF
Firstly, good article – you seem to be across all the relevant issues and figures that come to my mind as well.
But I think you miss the crucial distinction. It is not that pig farming is an unwise investment from a large company with easy access to cheap capital, in fact it seems a much smarter investment than steel production considering the states of the two industries. But what does a steel maker know about pig farming? Now I know there are many successful conglomerates out there with wide ranging products but I see more antagonism than synergies in this type of business structure.
How can you have a board that is best suited to make strategic calls on the steel industry and yet also the best suited for the pork industry. Surely a board deciding between investments in pork or steel is not as well suited as a market allocating capital between specialised firms in either field.
Thanks, Chris
hello chris, thanks for commenting, sorry for the late reply
you do have a point, there’s no synergy between the two operations of steel making and pork, but pork is just one of the many investments they have in non- steel activities.
I guess that as a non-steel activity investment, the board didn’t really weigh heavily on the idea whether or not it was appropriate/good synergy with the business. But rather wanted to allocate capital away to diversify away from the steel industry, rather than increase their exposure to it through synergy adding investments.
Contrast this to when a board decides to say for example invest in a steel making equipment manufacturer. they are indeed probably generating synergy between the two operations, but also increasing their exposure to the steel making industry.