Vale SA (NYSE:VALE) produces iron ore at a lower cash cost of $22 per metric ton than Australian rivals Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP), which produce at $25 per metric ton. A disadvantage for Vale, however, is the distance of its mines from Asian markets, where the company sells more than 60% of its total iron-ore volume. Shipment of ore from Brazil to Asia takes 60 to 70 days, with a shipping cost of about $17 per metric ton, while from Australia it takes nine days, with a shipping cost of $7 per metric ton.
To reduce the delivery time, Vale is developing the Teluk Rubiah Terminal, a distribution center and port in the state of Perak, in Malaysia, that is expected to be operational by October this year. The terminal consists of an iron-ore storage yard and marine terminal with annual handling capacity of 60 million metric tons. After construction of the storage yard, the company can stockpile iron ore in Malaysia and reduce its delivery time to Asian customers to less than 15 days -- one fourth of its current delivery time.
Significant improvement in delivery time will make Vale more competitive in Asia. It will help the company offset the additional iron-ore supply expected to come from Australian mines. Rio is planning to increase its annual production capacity to 290 million metric tons by the second quarter of this year, from 265 million metric tons last year. BHP is also aiming to increase its annual production to 270 million metric tons, from the current level of 212 million metric tons per year. Hence, reduction in the delivery time can help Vale retain its customers, which its rivals could otherwise capture.
Another advantage with this terminal is that it can anchor the Valemax, a vessel that can deliver about 400,000 tons of iron ore and is twice the Capesize vessel's capacity. Use of these large carriers will allow Vale to cut its shipping cost per metric ton by one-third compared to the cost of delivering iron ore by smaller vessels.
Vale is constructing a port in Malaysia, because Valemax's entry in its biggest market, China, is not allowed due to the country's ban over entry of overseas cargo vessels carrying volume of more than 300,000 metric tons. These vessels have to be anchored outside China, and shipment is delivered to the country through smaller vessels. Malaysia being close to China and other Asian countries, such as Japan and Taiwan where Vale has customers, will help the company minimize its shipping cost.
In addition, Vale is trying to make deals with Chinese shipping companies to operate its vessels. In October last year, the company signed a contract with Shandong Shipping Corporation to operate its four Valemax vessels for five years. Under this contract, these four vessels will trade under Shandong's name instead of Vale's, helping these vessels gain entry into China. The company is expecting to complete similar deals with other shipping companies as well. After completion of the Malaysian terminal and expected deals with Chinese shipping companies, Vale's cost structure will become competitive to its rivals.
Shale gas boom has presented opportunity to tap the U.S. market
Currently the U.S. market accounts for less than 1% of Vale's total iron-ore shipment. The U.S. steel mills are less interested in buying iron ore from Vale, and prefer mines of the Great Lakes region because of lower transportation costs. However, the shale-gas boom has created an opportunity for Vale to increase its business. Because of the increasing supply of shale gas, natural gas prices have fallen 66% since 2008 to less than $4 per million British thermal units, and the price is expected to stay below this level for at least next three to five years.
Given the low price of natural gas, many new steel plants are under consideration in the U.S., which will use natural gas instead of coal to purify iron ore, which is main ingredient in steel making. In this process, natural gas is used to convert iron-ore pellets into direct reduction iron, which is used to make steel. Purification of iron ore by using natural gas costs about $324 per ton, while through conventional methods steel plants have to bear about $406 per ton.
Vale is in talks with investors of two steel plant projects, and it expects to sign a pellet-supply contract with them this year. One project is with the Austrian company Voestalpine Group, which is opening a plant in Texas with an annual capacity of 2 million tons.
In addition, Vale is already supplying pellets through its 50-50 joint venture with BHP Billiton in Brazil to Nucor Corp's (NYSE:NUE) plant in Louisiana, which began in December and will produce about 2.5 million tons of direct reduction iron per year. With the expected increase in demand, Vale is considering restarting its three Brazilian pellet-feed plants, which were shut down due to weak demand from U.S. steel makers.
The U.S. steel industry will get a boost from natural-gas prices, which are expected to stay low for a long time. Revival of steel industry will increase demand of iron ore and pellets, which will help Vale to increase its U.S. sales volume due to its better quality iron ore.
Vale continues to focus on iron ore despite the expected price fall in coming years, because it produces iron ore at low cost. To strengthen its Asian business, where the company sells most of its iron ore, it is developing a distribution center and port in Malaysia, which is expected to be operational by October of this year. With this new center, the company will be able to stockpile iron ore in its storage yard, reducing delivery time to its Asian clients from 60 to 15 days.
Along with Asia, Vale also seeks to grow its business in the U.S. due to the revival of the country's steel sector because of the shale gas boom. Considering the company's growth prospects, there is potential upside for this stock.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.