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By Manolo Serapio Jr
MANILA, Jan 24 (Reuters) - Chinese steel mills have balked at global miner Rio Tinto's plan to charge a premium in long-term contracts for its highest grade of iron ore, rekindling the conflicts that caused the collapse of an annual pricing system seven years ago.
The world's second-biggest iron ore miner is seeking a premium of at least 15 cents per tonne above the index price for its flagship Pilbara Blend iron ore product, or PB fines, for all new long-term contracts, according to sources at two Chinese steel mills with knowledge of the talks.
Rio sells about 85 percent of its iron ore to China through contracts that can run up to five years, so a premium for its top product would boost earnings as the market builds on last year's unexpected price revival.
But Rio risks a backlash from its Chinese customers, who provide nearly half of its revenue. Those mills are just recovering from years of losses.
"As far as we know, none of the steel mills have accepted this," said a source from a Chinese mill that produces 10 million tonnes of steel a year and has a long-term contract with Rio.
"I think it's not fair to add some premium, it's not reasonable, it's ridiculous."
This is the first time Rio has sought a premium on its long-term contracts with Chinese mills since the industry ditched a four-decade system of pricing contracts annually in 2010. Since then, the contracts use indexes derived from spot market deals published by agencies including Platts and Metal Bulletin.
With iron ore prices tumbling to below $40 a tonne in 2015 from almost $200 four years earlier, miners have sought new ways to boost revenue.
Rivals BHP Billiton and Vale SA have in the past secured premiums for their high-grade products, the source said. But unlike Rio, which is seeking the premium from all Chinese clients, BHP and Vale only asked certain customers, the source added.
"It couldn't be accepted by the market," said the head of iron ore purchasing at one of China's biggest steel producers, of Rio's demand.
Top iron ore miner Vale said premiums for its high-grade iron ore such as Carajas fines are determined by the market.
"It is the market who decides the premium daily and the premium is also published in indexes," Vale said in response to Reuters' query.
Officials at Rio and BHP did not respond to requests for comment.
PB fines is popular in China for its low impurity levels as the country has stepped up anti-pollution efforts in the steel industry. Amid strong demand, it sold between $1 and $3 a tonne above the index price last year in the spot market, and the current premium is $2, two traders said.
Rio earlier sought a premium of up to $1 per tonne from Chinese mills renewing contracts.
Rio secured a record $2.50 a tonne premium for PB fines for January to April 2017 from trading firms, up from $1.50 in September to December 2016, two trading sources said.
Chinese mills contend the issue is not about the premium being big or small. "It's about whether it's reasonable," said the first source at a mill, adding that accepting a premium now means it can be negotiated higher in future.
"They can't ask for a special premium because we don't have a special discount when the market is bad," he said.
"Before this, pricing is negotiated every year. If the iron ore supplier now asks for a premium then we go back to the previous pricing system. So both iron ore suppliers and steel mills face a difficult situation."
Because of oversupply, it is difficult for foreign miners to fix a premium for iron ore, said Li Xinchuang, vice-secretary general of the China Iron and Steel Association. Scrap steel supply is also rising as China tackles a glut.
"All outdated facilities will be closed very quickly. Then there will be a lot of scrap and this will reduce iron ore demand," Li told Reuters by phone.
Reporting by Manolo Serapio Jr.; Additional reporting by Jim Regan in Sydney; Editing by Christian Schmollinger