Vale's Earnings Will Contend With Weak Iron Ore Prices

| About: Vale S.A. (VALE)

Vale (NYSE:VALE), the world’s largest iron ore mining company, will announce its second quarter earnings results on Wednesday, August 7. We expect low iron ore prices to have a significantly negative impact on its year-over-year earnings since iron ore constitutes the majority of its business.

We would like to highlight two key pieces of news in the second quarter. Firstly, the company received a key environmental license for its S11D project in July which prompted the board to approve the entire project. It includes investments in the S11D mine, processing plant, railway capacity and port. The S11D project is important to Vale’s future growth and will enable it to compete with other mining majors like Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP). These companies enjoy a cost advantage over Vale due to shorter shipping distances between Australia and China than between Brazil and China. Vale’s production comes mainly from Brazil.

Secondly, Vale announced a 30% reduction in its coal export targets from Mozambique due to incidences of labor disruption and heavy flooding that rendered its railway line unusable temporarily. The exports are expected to fall short of the original target of 4.9 million tonnes by around 1.5 million tonnes.

Iron Ore Prices

Given the lower iron ore prices this year, we expect the company to post lower year-over-year revenues and profits. [1]

As expected, this year began on a positive note for iron ore miners. The price of iron ore continued to rise in January and February from the previous quarter due to the restocking being carried out by Chinese steel mills. However, once the restocking was done by the end of February, prices began falling. The Chinese government then came out with stringent rules to curb the housing market which appeared to be in a bubble. This reduced the demand for steel, in turn impacting the demand for iron ore. The situation didn’t improve in the second quarter with manufacturing activity slowing down and China reporting low economic growth rates.

China is the world’s biggest consumer of commodities and its economic growth data for the second quarter was below expectation. It reported a Gross Domestic Product (GDP) growth rate of 7.5% in Q2 2013, which was much lower than market estimates and the previous quarter’s figure of 7.7%. As a result, prices of nearly all major commodities, including iron ore, took a beating. The situation is not expected to improve any time soon given that the government is trying to reorient the economy towards a consumption led growth model and away from an investment led one.

Iron ore miners are in for a double whammy as supplies are expected to surge over the next few years. Australia is a major exporter of iron ore to China and other countries, so its economic agencies track the iron ore market very closely. According to the Bureau of Resource and Energy Economics (BREE), the official Australian commodities forecasting agency, iron ore prices will decline going forward and reach its lowest levels around 2018. This is due to a lot of additional production capacity scheduled to come online in this period and a non-commensurate expected rise in demand. Beyond 2018, the balance between demand and supply is likely to be more even. [2]

The S11D Project

The S11D project is located in the Brazilian state of Para. It has an estimated nominal capacity of 90 million tonnes of iron ore per year and proven iron ore reserves of 4.2 billion tonnes so far. To put the production figure in perspective, Vale produced 258 million tonnes of iron ore and about 45 million tonnes of iron ore pellets in 2012. Thus, the S11D project will augment production capacity considerably once it starts up in the second half of 2016 and achieves full capacity in 2018. Also, the iron ore produced from this mine will have an average ferrous content of 66.7%, low impurities and an estimated cash cost (mine, plant, railway and port after royalties) of $15 per metric tonne.

The high quality iron ore from S11D will be of high value to the steel industry because it implies higher productivity, lower fuel consumption and thus lower carbon emissions. Consumers typically tend to use a blend of different grades of iron ore. Since the quality of iron ore around the world has been diminishing in general, the demand for high grade ore is expected to rise in order to maintain blend quality. This will make demand for iron ore from S11D less sensitive to the vagaries of economic cycles.

Despite its large scale, the project will have a low environmental footprint. This aspect of the project is crucial because it will allow the company to avoid fines and potential disputes with environmental authorities.

Mozambique Export Targets Lowered

Heavy rains and flooding in the Zambezi Valley in the central part of Mozambique closed railways in February. The Sena line remained shut for two weeks resulting in a significant disruption to operations. Trains were temporarily stopped on the line causing the company to invoke the force majeure clause on its client contracts. This clause is used to protect a company from liabilities when disruptions are caused by forces beyond the company’s control such as natural forces and disasters. [3]

There was also a two-day halt in shipments earlier this month as protesters blocked the Sena line demanding compensation. (Brazil’s Vale Moatize Coal Shipments Again Halted By Protests, Fox Business)

Around 10,000-12,000 tonnes of coal are shipped daily from Moatize, so the total disruption of close to 16 days cannot account for the steep export target reduction. We think that the major reason is anticipation by the company that it could face similar disruptions to operations for the rest of the year, and the present infrastructure is not conducive for meeting ambitious targets. Perhaps the management will shed more light on this in the earnings conference call, and also mention the financial impact on the company’s results.

We have a Trefis price estimate for Vale of $20, which will be updated after the earnings results.


  1. Iron Ore Spot Price Chart, YCharts
  2. Australia predicts fall in iron ore price, Financial Times
  3. Vale reduces forecast by 30% for coal exports from Mozambique,

Disclosure: No positions