The bull case for Vale (VALE) is as a materials play on China growth and as a low-cost producer of iron ore (accounting for substantially all of the firm's operating cash margin). After a good run, taking the stock from a recent low of $16 in September to $21 today, investors may now be gilding the lily.
As new iron ore supply comes online, we expect a secular decline in prices independently of likely growth in the Chinese economy (which imports over 70% of the "seaborne" trade in iron ore). Furthermore, as customers sharpen focus on price, Vale will face a more adverse impact from higher shipping costs to China from its Brazilian operations than those faced by Australia-based competitors such as Rio Tinto (RIO) and BHP Billiton (BHP).
Vale's geographic disadvantage is understood in principle, but investors may not fully appreciate that the financial impact will be greater with falling iron ore prices. In particular, Vale has noted that it is more able to offset higher shipping costs with better quality ore and customer service at times when the market is tight, as it has been in recent years, than when market conditions ease as is likely going forward.
This note argues that, with industry supply constraints easing, investors need to focus more on the ore price realized by Vale, net of freight costs, than the likely growth in the Chinese economy per se or Vale's advantaged production costs before shipping.
Expect Secular Decline in Iron Ore Prices
While China may continue to grow, this will likely not translate into increasing iron ore prices. As the industry's lagged supply-response catches up with Chinese demand for iron ore, pricing will transition from a "scarcity" regime (where production constraints require that demand decline, through self-rationing by buyers, to meet supply) to a "sufficiency" regime (where available production capacity allows supply to increase, through increased output, to meet demand).
The result of this regime shift there is likely to be secular decline in iron ore prices. The CEO of BHP, Mr. Marcus Kloppers, has persistently drawn attention to the shift. Last September, he commented "the scarcity pricing seen in recent years is unlikely to be repeated" and added the following month that "the opportunities that lie ahead will be volumetric as opposed to price based." (For more information, see the article on iron-ore pricing by Seeking Alpha contributor, Mr. Paulo Santos, and further commentary by Mr. Kloppers).
Some iron ore forecasts are strikingly bearish. For example, one commodity strategist commented in September, "there's a lot of supply coming into the market in the next few years, which is going to lead to oversupply and lower prices in the medium and longer term,'' and forecast a price of $US75/tonne in 2015. As shown in the chart below from indexmundi, this compares with a peak price in February of ~$190/tonne and the current price, after a dip below $90/tonne in September, of ~$140/tonne:
China import Iron Ore Fines (62% iron content, CFR Tianjin port)
Estimating Vale's Cost Position
Vale has responded to concerns about easing conditions in the iron ore market by emphasizing its cost leadership. For example, the head of iron ore, Mr. Jose Carlos Martins, commented last August: "We are one of the most efficient producers. We will be the last to leave the market."
Industry analysts agree pegging Vale's cost-plus-freight or "CIF cost" for China delivery at just over $40/dry tonne; as the supply curve below shows, this is only slightly higher than firms, such as RIO and BHP, with mines in Australia which are more conveniently located for the Chinese market and had a shipping cost advantage in late 2012 that we estimate at ~$10/tonne - see below for analysis.
We can arrive at some independent validation of the ~$40/tonne estimate shown in the supply curve for Vale's cash production costs because the firm reports revenue and operating EBITDA for its ferrous minerals segment. (It also reports revenue for iron ore and iron ore pellets but provides EBITDA only for the ferrous minerals segment, which includes some manganese ore and ferro-alloys, as a whole; our analysis assumes these additional items do not contribute meaningfully to cash margins).
Subtracting the EBITDA from the revenue gives us cash costs which we convert to a per-tonne basis using Vale's report for sales volume. As shown below, the conclusion is that, over the last five quarters, Vale's average cash production cost is $42/tonne with meaningful variation only in 1Q12 and 3Q12.
|Revenue - $mm||12,479||10,620||7,851||8,658||7,340|
|Volume - million tonnes||77.5||80.7||65.2||75.3||78.2|
|Cash Cost - per tonne||42.7||42.9||47.2||40.7||37.9|
The results seems consistent with the $40/tonne estimate shown in the supply-cost curve. However, Vale reports its revenue net of shipping costs which must be added back in our analysis to generate the CIF figures relevant to a supply-cost curve for China. We therefore turn to estimating the impact of shipping costs.
Estimating Vale's Shipping Costs
In early December, shipping rates to China (on large "Capesize" vessels - i.e., vessels too large to pass through the Suez canal) were $19/tonne from Brazil and $7.50/tonne from Australia. (Shipping rates are quoted per wet tonne while iron ore prices are quoted per dry tonne; this means the rates need to be grossed up to account for the average 10% moisture in a standard ore cargo).
While shipping rates can be highly volatile, the figure for Australia is consistent with comments from cost leader, RIO, that its cash production costs were ~$25/tonne in early 2012 compared with a CIF China cost, including royalties as well as shipping, from the supply-cost chart of ~$33-35/tonne. (We note in passing that BHP's iron ore operations are in the same Pilbara region of Australia as RIO's with cash production costs only a few dollars per tonne higher).
We can also estimate the impact of shipping costs from Vale's financial disclosures. Specifically, we can compare market prices for iron ore, CIF China, with Vale's report for its realized price which is net of shipping. As shown below, over the last five quarters, Vale realized an average ~$25+/tonne less than the market price for iron ore. (The quarterly market prices are calculated as an average of monthly prices sourced from IndexMundi; these averages differ from a true market benchmark to the extent that Vale's ore sales in a quarter are not spread evenly across the months):
|Iron Ore Price - $/dry tonne||3Q11||4Q11||1Q12||2Q12||3Q12|
|Realized by Vale||151.3||121.4||109.3||103.3||83.7|
Allowing for the likelihood that Vale has special pricing arrangements with large customers (and other adjustments such as royalties), our analysis is not inconsistent with shipping rates of ~$20/tonne. In particular, it suggests the claim in Vale's annual report that "when market demand is very strong, our quality differential is in many cases more valuable to customers than a freight differential" has not fully applied during the period of the analysis.
Even assuming Vale's quality differential fully offsets the freight differential of ~$10+/tonne (given shipping costs from Australia are ~$10 or less compared with our estimate of ~$20 from Brazil for Vale), our analysis suggests Vale's CIF cost for China delivery is closer to $50/tonne than the $40/tonne shown in the above supply-cost curve. Furthermore, this gap will likely widen as ore market conditions ease so that Vale's quality differential becomes less valuable to customers.
Managing Shipping Costs with VLOCs
Under these circumstances, it is understandable that Vale is working intensively to reduce shipping costs including, in particular, through the charter of very large ore carriers or "VLOC"s. The firm ordered 35 of these Valemax-branded ships (with capacity of 380-400,000 deadweight tonnes or DWT versus the standard for dry bulk carriers of ~180,000) with the first, ValeBrasil, delivered in 2011 and the fleet expected to be completed during 2013.
The VLOCs were expected to reduce shipping costs by 20-25% but, in January, China's Ministry of Commerce banned dry bulk carriers with capacity above 300,000 tonnes from entering Chinese ports. As a result, the VLOCs are staged at other Asian ports and their ore cargoes transferred to smaller ships for delivery into China; this likely reduced Vale's expected savings by half.
The iron ore market is undergoing a shift in regime from scarcity pricing, where supply is not sufficient to meet demand, to sufficiently pricing where it is. As a consequence, there will likely be a secular decline in iron-ore prices with some commentators forecasting a long-run price of $75/tonne versus the current $140/tonne and the recent peak, in February, of $190/tonne.
Vale has responded to investor concerns around the likely easing of the iron ore market by emphasizing its cost leadership. However, for delivery to the important Chinese market, this partly rests on offsetting a locational disadvantage in Brazil against Australian producers (which gives rise to an adverse freight differential of ~$10/tonne) with better quality ore and customer service.
Even with a full offset, our analysis suggests Vale's CIF cost for the Chinese market is ~$50/tonne versus consensus which appears to be closer to ~$40/tonne. Furthermore, Vale has been clear that, in the easier ore market which is expected, customers place less value on its quality differential; as a result, there will likely be less opportunity to offset the adverse freight differential.