A number iron ore producers–including Vale (VALE), BHP Billiton (BHP), Cliffs Natural Resources (CLF), and Best Ideas Newsletter portfolio holding Rio Tinto (RIO)–have seen share prices jump after reports that Chinese demand for the key ingredient in steel production will increase in the second half of 2015. This is good news for iron ore producers, as approximately half of the world’s steel is produced in China.
According to Vale CEO Murilo Ferreira, Chinese imports of iron ore will increase significantly in the back half of this year as domestic production is expected to be down ~200 million metric tons. According to Ferreira, a significant amount–more than most realize–of Chinese iron ore producers have ceased operations, boosting the country’s import demand. Iron ore prices have decreased ~60% from peak levels in 2013, and producers have not been spared the pain.
Supply expansions in Australia and Brazil, two areas commonly associated with iron ore production, and the economic slowdown in China helped drive prices to the lowest point in a decade in mid-April. Prices have since rallied ~39% on the aforementioned anticipation of increasing demand in China. Also increasing the anticipated demand in the near term is the closing of many high-cost mines in less-developed areas across the globe, including those in China. Vale expects the global seaborne market for iron ore will increase 3.6% in 2015.
However, Chinese iron imports in the month of May decreased 12% from April, and on an adjusted basis (accounting for the number of business days in a month), iron ore imports were at the slowest pace since last November. The 70.87 metric tons of imported iron in the month of May represents an 8.4% decrease from the comparable period in 2014. Prices in May posted the largest increase in nearly two years as stockpiles at Chinese ports fell by record levels, but this may be more a result of a conscious effort by the country to destock.
In relation to the slowing Chinese economy, global oversupply of many metals markets is not going away. Recent expansions by BHP Billiton and Vale are expected to swell the global surplus of iron ore to ~215 million metric tons by 2018, compared to the expected ~45 million metric ton surplus in 2015. The price movement of iron ore is a prime example of the delicacy of supply and demand within a cyclical, commoditized industry. The normalization of growth of the Chinese economy will help to eventually balance the market, but before then, prices are likely to drop near record lows once again until high-cost suppliers are forced out of the market, normalizing supply and representing a truer tightening of the market.
The future trajectory of the price of iron ore has probably never been more important to global participants. Balance sheets across the diversified mining industry are mired in debt, many at alarming levels. A look at their 16 page reports tells the story quite well. One of the few firms with a solid balance sheet, however, is Rio Tinto, a Best Ideas Newsletter portfolio holding. We like Rio’s focus on driving free cash flow by improving its capital allocation and efficiency. The firm also sports a nice dividend yield. We value shares at nearly $60 each.
Though the second half of 2015 looks more promising than the environment of the past few years, an expected iron ore global surplus beginning in 2016 cannot be ruled out. BHP’s CEO explained that his firm does not believe Australian iron producers should slow production during periods of economic weakness or downward pricing pressure, an indication that the global surplus may be more difficult to overcome than some initially expected. In this light, it’s difficult to be very positive on the long-term outlook for the iron ore markets, regardless what happens through the remainder of 2015.
We only have a very small position levered to mining and iron-ore exposure specifically, and the recent developments in the iron ore market speak to why. Most mining companies are held down by their massive debt loads and all participants are subject to cyclical commodity prices, a dangerous combination in our minds. We’re sticking with Rio, and we think it is the best risk-adjusted exposure to the global iron-ore market, with the most valuation upside.
Metals & Mining – Diversified: BHP, CLF, FCX, RIO, SCCO, SLW, VALE
Metals & Mining – Steel: AKS, GGB, MT, NUE, PKX, STLD, X, ZEUS