Iron Ore Prices Have Fallen
Since hitting a high of nearly $160 in February, prices of iron ore have fallen, and fallen fast. Just this Friday, iron ore prices fell to $110 per metric tonne, and we see no immediate catalyst to improve demand. At this point, the odds of price appreciation don’t look favorable.
The warning signs have been communicated during the past several months. In March, China accused the big three of iron ore production of price collusion during steel mill stocking season. In a note published on March 25, 2013, we warned that even industry insiders were bearish about the price of iron ore in the back half of the year.
“Rio Tinto’s Pilbara iron ore President Greg Lilleyman anticipates prices to fall in the back half of 2013, saying:
‘We are going to see a number of projects bring supply on in the second half of this year around the globe. Inevitably that is going to put some downward pressure on iron ore prices.’”
In fact, Vale’s (click ticker for report: ) CFO agreed, speculating that prices will bounce between $110 and $180 per metric tonne. Therefore, we haven’t been shocked by the decline in prices.
Source: IndexMundi.com
Above is a 10-year chart of iron ore prices, and we can see that prices have come a long way from 2003 (the far left of the chart). Using the conservative $110 per metric tonne we’re seeing in the spot market right now, prices are almost 7.5x higher than they were just ten years ago!
Still, let’s not forget this fact—the fundamentals of the iron ore market are significantly better than they were back then, and while the likes of BHP (click ticker for report: ) and Rio Tinto (click ticker for report: ) are likely to see margin compression, it doesn’t mean the companies won’t be able to have profitable iron ore segments. Cash costs per iron ore in certain regions may be just slightly above half the current spot price! Cliffs Natural (click ticker for report: ), for example, is forecasting US iron ore cash-cost-per-ton of $65-$70 during 2013.
How Far Will Iron Ore Prices Fall?
Is a return to $13 iron ore prices possible? We don’t think so. Not only was the money supply smaller 10 years ago, but the real size of global gross domestic product is much higher, and resource hungry emerging markets still continue to gobble up resources. However, there is now little doubt that China’s economy is slowing, especially after the HBSC PMI for May punched in at a mild contraction of 49.2.
But just how important is China? Very. The country has been the main driver of global demand for minerals and metals during the past few years, and in 2012, Chinese demand represented nearly 70% of global demand for seaborne iron ore. A look at the history of Rio’s iron ore shipments to China over the past several decades reveals the country’s increased importance.
Image Source: Rio Tinto
China’s premier Li Keqiuang also announced that the country is targeting 7% GDP growth for the duration of this decade, compared to previous goals of 7.5%. Slowing from 7.5% annual growth to 7% annual growth may not seem like a big deal, but the Chinese landscape differs greatly from the Western world. The country has a slightly smaller base, but it also dwarfs most other countries around the globe in population size. Therefore, China’s economic growth needs to maintain a strong velocity in order for everyone to benefit. If growth slows and lower-class income/wealth greatly stagnates, we could see the elephant in the room emerge—social unrest in China.
But even in the event of social unrest, a fall into the teens seems very unlikely. Under a worst-case scenario, we think another 20-30% price drop in iron ore is reasonable (to the levels of the Great Recession). Under a base-case scenario, we think the current level of $100-$110 is appropriate, and under a best-case scenario, a slight increase from current levels is feasible.
What Are Miners Doing About the Price Drop?
Vale (VALE)
During the first quarter of 2013, Brazilian miner Vale showed increases in operating income, operating margin, earnings and cash flow generation. However, most of these improvements were driven by the cost side, as operating costs and SG&A fell significantly in the period. Importantly, the company firmly acknowledges that “commodity prices have lost strength…with the recognition of the end of a period of above long-term trend global growth.”
Image Source: Vale, Barcelona Presentation, May 14, 2013
Capital efficiency has become Vale’s main strategic priority: deploying capital to a smaller number of projects and divesting non-core properties (“shelving Simandou and Rio Colorado”). Yet, the firm remains focused on rebuilding its share of the Brazilian iron-ore market, which has dwindled in recent years. We’re keeping a close eye on its investing activities.
Rio Tinto (RIO)
Best Ideas Newsletter holding Rio Tinto is undergoing aggressive asset realization. The firm appears to be exploring an IPO of its diamond business which could fetch a few billion dollars. Rio is also looking to divest its 59% stake in the Iron Ore Company of Canada, with Glencore Xstrata and Blackstone expected to be in the bidding. We estimate a deal could fetch at least $4 billion for Rio, but we acknowledge that now is a difficult time to be selling assets. If the firm generates cash from these businesses, we anticipate debt reduction and shareholder returns to be the primary uses.
The miner has also identified more than 1500 cost reduction initiatives ranging from employee reductions in its energy division to enhancements in mine maintenance schedules in its iron-ore segment. By our estimates, Rio remains on track to achieve roughly $750 million in cost reductions from 2012 levels.
BHP Billiton (BHP)
As for BHP, the company is also undertaking an ambitious plan to refocus on profitable businesses. Unfortunately, the best time to sell mining assets is often when it looks like the best time to own mining assets. In any case, we think CEO Andrew Mackenzie will be able to realize his target of $5 billion in asset sales and $1 billion in cost savings this year. It also appears that as BHP improves its financial footing, the firm will look to boost returns of capital to shareholders. Though this may ultimately be positive for shareholders (as they will be able to allocate money from the volatile mining business to other areas), it could cause the miner to miss asset buying opportunities, as competitors such as Anglo also look to divest assets.
Rumors have also persisted during the past month that the company will take a stab at purchasing potash producer Mosaic (click ticker for report: ) after its bid for Potash (click ticker for report: ) was denied by Canadian regulators. Without question, the outlook for potash demand looks much more stable than other commodities since it is essential for farming. As far as we can tell, agriculture could remain on the uptrend for the next several years, if not decades. Still, whether or not the deal adds value will come down to the price of the transaction. We peg Mosaic’s fair value at $60 per share, but we think the company could pay up to $78 and still receive a fair return.
Cliffs Natural (CLF)
After slashing its dividend, Cliffs Natural continues to take deliberate measures to reduce debt and improve its cash position, while cutting costs across the board. During its first quarter, global iron ore sales volumes contracted 10%, something that’s difficult to overlook. And while the firm’s sales volume expectation was increased to 21 million tons from 20 million tons in 2013 as a result of increased pellet demand in the US, we’re just not comfortable with a firm cutting its dividend to preserve cash flow.
Image Source: Cliffs Natural
Valuentum’s Take
Overall, we continue to be very cautious on the mining sector. Lots of promises are being made to lower costs and divest less profitable assets, but execution will be difficult as most companies are moving in the same direction. We’re not looking to put new capital to work in the space at this time.