The forthcoming bankruptcy court battle between the state and Essar Steel Minnesota over a stalled project in Nashwauk, Minn., teaches many economic lessons.
First, it is an example of why bankruptcy is a necessary evil for an efficient economy. Aggrieved creditors see unfairness when a court rules they cannot recover money lent or get payment for work and goods provided. Yet decrees discharging debt recognize the practical reality that the money simply isn’t there. If all the debt of a failed enterprise cannot be paid, it is better to have established rules to determine who gets how much than to have a free-for-all.
Moreover, if laws make failure of a business too onerous, then people will be more cautious about making investments and taking risks. Less investment means slower growth of output of goods and services. Fewer needs and wants of people are met. Society is worse off.
On the other hand, if it is too easy to write off debt, entrepreneurs take on too much risk. Resources disappear down rat holes, and this, in turn, also creates a disincentive. In response, lenders and vendors must spend more time and money researching the viability of customers. Interest rates will be higher for all borrowers because more resources will go into such due diligence and into debt write-offs.
Writing bankruptcy laws that strike an economically efficient medium is hard. No matter how one does it, injustices occur. And bankruptcy gets even more complicated when government itself is either a debtor, as is the case with Puerto Rico, or a creditor, as is the state of Minnesota with Essar Steel.
More broadly, Essar exemplifies the pitfalls of technological change taking place in a particular industry against a broad backdrop of international economic cycles.
Start with a review of events: Northeast Minnesota produced millions of tons of “direct-shipping” iron ores for decades. These, including hematite and magnetite, required little processing before transport to blast furnaces for their transformation into iron itself.
Such ores were finite, however, and the state sponsored research into how lower grade ore, especially taconite, which is especially abundant, might be used. University of Minnesota researchers came up with methods, but these required enormous capital investments in processing plants. The state had to amend its constitution in 1964 to prohibit taxation of taconite for at least 25 years to induce mining companies to build such plants. Many were built.
During this time, however, new high grade ore was found in Brazil, Venezuela, Australia and elsewhere. Global steel production grew, first in Japan, South Korea and Brazil and later in China and India. The traditional U.S. steel industry stagnated; new plants (like the North Star Steel plant, now Gerdau, down the river from St. Paul) were electric minimills using scrap steel as an input.
In the 1980s, many mines closed. Existing firms went broke or were bought out, workforce numbers fell sharply and union contracts were renegotiated. One closed mine was at Nashwauk.
But even as U.S. iron ore and steel went through a shake-out, research continued. The blast furnace process of converting ore to iron is centuries old. And shipping millions of tons of waste material from mines to minimills always seemed inefficient. So technology for “direct reduction” of ore to iron at the mine emerged. Plans for building such a plant at Nashwauk emerged in the mid-1990s.
In the new century, economic growth in China put the world into a commodity price boom. Along with farm commodities and metals, iron ore prices increased as much as 10 times over. Projects that were not financially viable with low commodity prices now seemed like good ideas.
Enter Essar, a Mumbai, India-based company, which bought its way into the Nashwauk project a decade ago. It proposed a new taconite plant combined with a direct-reduction facility (DRI) at a total cost near $2 billion.
As is usual, it sought government subsidies. Minnesota approved a $64 million economic development grant and other incentives in the closing days of Gov. Tim Pawlenty’s administration. Construction and ordering of equipment began soon thereafter.
Unfortunately, the project coincided with the global economy slump of 2008-2009 and as Chinese economic growth started slowing after three decades of rapid expansion. Essar Steel Minnesota fell into financial straits almost immediately. The DRI plant was axed. There were frantic negotiations with outside investors, together with periodic construction stoppages and chronic late payments to contractors and vendors. Essar Minnesota missed one milestone or deadline after another.
There are at least three separate sets of interests for Minnesotans. One is the actual state money sunk in the project. Unlike the vendors of mining trucks, for example, taxpayers have no enforceable security interest and no way of getting the money back. It is water over the dam.
Secondly, there are the Minnesota-based contractors and vendors who are being stiffed. A few have physical property, like trucks and shovels, in which they retain a security interest that sets them aside from general creditors and which can be repossessed. But most have little recourse other than what they will get in bankruptcy court.
Thirdly, there is the Iron Range as a region, which anticipated growth in employment and economic activity. When the DRI plant was still in the picture, it held out the hope that a new technology might revitalize the entire iron ore sector the way taconite processing had after the direct shipping ores were mined out in the late 1950s. That hope is probably diminished now, but not gone entirely.
We are now at the stage where it is clear that considerable losses have to be shared somehow, but that considerable value also is in place. The fight is over who bears the losses and who will retain any existing value.
The primary clout the state has is that the ore was to be mined on land leased from the state rather than actually owned by Essar. Gov. Mark Dayton has canceled those leases and has entered into talks with Cliffs Natural Resources, a major operator of other mines, based in Cleveland, and a competitor with Essar.
Just prior to Dayton’s move, Essar filed papers to enter into a Chapter 11 bankruptcy, which it claims protects the mineral leases. Essar says it wants to complete the project.
Economic lessons? One is the idea of sunk costs, investments that have been made that are not recoverable. A new mining truck on site can be dismantled and/or sold elsewhere and thus is not a sunk cost, but concrete and rebar in the enormous foundations needed for machinery of this scale is not recoverable and thus is sunk. Sunk costs are financial spilled milk. One has to ignore them going forward.
Another lesson is that sales by small businesses to a large project are “lumpy.” A farmer can apply 100 pounds of fertilizer per acre or 105 or 117. But she cannot go from having one tractor to 1.05 or 1.17 tractors. Tractors are “lumpy” — you either have one or two or three, but not some fraction of a tractor. Similarly, a concrete business bidding on work at a new ore facility is in an all-or-nothing situation. They can take on a very large and potentially profitable deal that also exposes them to large losses in case of default. Or they opt out completely. But they usually cannot calibrate their share of the business to a level that will not cause financial harm if the project runs onto the rocks.
The situation is something like the horse track at Canterbury Downs decades ago. The original investors could not make money under the agreed terms. They could have sold at a loss to some other investors. Once in place, a new buyer could make a financial go of the track as long as the purchase price was low enough. But the original investors did not want to take such a loss. They first tried many gambits to change the terms of the original deal through having the state allow other gambling activities on site. In the same way, the current owners of the Essar facility, now largely hedge funds, would like a sweeter deal from the state and others so as to keep their venture afloat.
Bankruptcy, in particular Chapter 11, is not about killing a business; it’s about saving a business. The basic premise is that often it is better for society as a whole and for most creditors if an enterprise keeps operating than if it is liquidated. That is true in this case. Construction is far along. Society would be better off if the project were completed than if what is in place were left to rust. But the next step, as Dayton has acknowledged, will likely be made in federal court.