Imagine this: Iron ore averages US$35, oil rises to US$50, royalties are raised in Brazil. Each of these events is quite possible: the iron ore already dropped so much, why not an extra 15%? Oil could recover if Saudi Arabia decides to cut its production and this could raise Vale's (NYSE:VALE) freight cost back to the same US$16.4 per ton it had in the 3Q15. Brazil has been talking about the royalties increase from 2% (with many deductions, so an effective 1%) to 4% without deduction for iron ore along time now. If the government wasn't so busy dodging the impeachment and wasn't so weak due to the corruption scandals, the raise would have been approved already by now. Part of the reason why it wasn't approved was to help the producers in this time of record low ore prices, but this excuse doesn't quite cut it anymore as many industries such as steel and car makers are already closing factories and laying off tens of thousands of workers due to the economic collapse in the country. The government, on the other hand, is so desperate to find money to fix the budget hole that instead of helping those industries, it in fact rolled back previous tax cuts. If the government is willing to raise taxes in key industrial sectors where tens of thousands of jobs are being lost, and where it has a huge stake at due to its connections with the unions, why wouldn't it raise taxes for the unpopular mineral extraction sector?
A final danger is that Vale would be forced to pay a large share of the Mariana disaster clean-up bill. Samarco might not be in position to pay much, even if it starts producing again, as it will need to pay debt interests, fight against low iron ore prices, pay for the reinforcement of the dams, etc. The latest proposition by the Brazilian government was US$5 billion for the main costs plus $500million of other minor costs. Let's consider that the costs will be split over the next 5 years and that Samarco can cover $500 millions. This would leave Vale with a bill of US$500 million per year, since it has to pay half of whatever Samarco cannot cover (BHP owns the other half of the costs).
There is also the danger that Vale would no longer be able to pull off the huge cost savings that it has achieved so far. After all a large part of it was due to the depreciation of the Brazilian real and there is only so much one can achieve in cost-savings before it starts compromising safety. Vale already lowered its C1 cash cost from $22 to $12.7 year-to-year in 3Q15, so there isn't much room to improve here until S11D comes online. S11D is projected to have a C1 cash cost of US$7 per ton and is projected to lower Vale's combined C1 cash cost to US$10 per ton.
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Vale's truckless system in Carajás. Source: vale.com
In this article I will calculate Vale's cash flow for 2016, 2017 and 2018 in three key iron ore price points: $35, $45 and $55. And then check if the company will have enough cash to pay its bills, refinance its debts, pay debt interests and if anything is left for dividends. But first, let's take a look at the outlook for the iron ore price to try to guess which of these price-points is most likely:
My outlook for iron ore
I won't pretend that I know how much iron ore will cost in 1 or 2 years. But then again, I don't think that anyone can predict that. Surely the miner company CEO's can't, as proven by statements from Vale that "it can't get any lower than $120" and from Rio Tinto that "$30 Iron Ore is Fantasy Land". The futures markets also don't say much, they seem to be permanently stuck at "in 1 year it will cost $10 less than now", and this was consistently wrong (it was too optimistic). But despite that, one can form some kind of general outlook due to the cycles in steel production in various countries and in general in the world.
One particularly unnerving chart is the cycle of global steel consumption per capita, shown bellow. If this chart is right, then it could be that the best days are already behind us, and the next frenetic investment boom, the kind that lead to $180 iron ore prices, will only start in 30 years from now. I don't know about you, but for me that's an awful lot of time. Also note the general downtrend of the chart: this is clearly caused by the shift in population growth from industrialized places (Americas, Europe, East Asia) to very poor places (Africa, South Asia). If you are already worried by demographics, then there is no need to worry about this downtrend as well, it is mostly the same thing.
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My original bet in iron ore was based on the idea that China would still grow a lot. It was based on the fact that its per capita income still has a lot to catch up with the developed world. But I was wrong, and China seems to have reached the end of its fast expansion of steel consumption. In fact its production dropped 2.3% last year to 803.8 million tons. Even worse for iron ore producers is that the total global steel production dropped 2.8% last year to 1.62 billion tons, just under half of the total produced by China. A real problem in China is demographics. Working population started falling back already in 2012 (3.45 million down y-o-y), reaching 919.5 million in 2013 (2.44 million down y-o-y). If the population is not increasing, then why build millions of new houses every year? And construction is the major steel consumer. Summing up, there is no evidence to support the idea that China will increase its steel production significantly. Most likely it will very slowly go down from here.
So let's fast-forward to the next big steel consumer: India. The current predictions puts India as the next big thing, but for some time still it will merely offset China's slowdown. Projections show India getting more significant in steel production only in 2021. So this means we still have many hard years ahead of us. Besides that, there are many reason to believe that India's rise will not be nearly as fast or spectacular as China's rise was. India is much more chaotic, much less centralized and its democracy means that it cannot ignore worker demands and pollution like China did. It also has much more serious religious conflicts and lacks the focus on growth at all costs that made China big. Summing up, India will be big, but not as much as China.
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Can Vale survive a nightmare scenario?
Each of these four dangers mentioned before (iron ore price, royalties, oil price and Samarco accident bill) is quite possible alone and the nightmare scenario for Vale would be if all of them happen at the same time. In this case would Vale survive or would it bankrupt? And what potential upside for higher iron ore price averages? Timing is everything here, and luckily the Brazilian government is slow so the royalties increase will take time. The oil price can change very fast, however.
In the nightmare scenario for 2016 and 2017 the initial result would be a C1 cash cost of $12.7, a freight cost of US$16 and royalties & expenses of U$5.6 ($1.2 increase due to new royalties), to a total cost of US$34.3 per ton, above our nightmare scenario ore price of $35. Vale would pretty much break-even in its iron ore operations.
The company will most likely keep making some money from base metals and fertilizers, although not much, and coal will be a drag until the Moatize project is finished, when hopefully it will finally break-even at least. The company also needs money to pay for its investments (CAPEX), for debt interest and to cover the Mariana disaster bill. All these cash flow items are summarized in this table:
|US$ M||US$ M||US$ M|
|CAPEX for coal mine in Mozambique, Irabiritos, CSP and Major Replacements||-800||-600||-500|
|CAPEX for S11D||-2 200||-1 500||-500|
|EBITA Base metals||500||500||500|
|EBITA Iron Ore||(<price> minus 35) * 300||(<price> minus 32) * 300|
|Debt interest||-1 500||-1 500||-1 500|
|Mariana disaster cost||-500||-500||-500|
|Asset sales||1 000||1 000||zero|
|Total: Iron Ore avg. $35||-3 500||-1 600||-1 100|
|Total: Iron Ore avg. $45||-500||1 400||1 900|
|Total: Iron Ore avg. $55||2 500||4 600||4 900|
|Debt Refinance Needs||2 100||2 700||3 500|
So in the nightmare scenario I see a cash flow shortfall of $5 billion for 2016 and 2017 to pay the bills plus almost $5 billion to refinance debt, to a total $10 billion. its a tricky situation, but I still think that Vale could use Europe's QE to its advantage and issue EUR denominated bonds. The interest rates in Europe are so desperately low that I think that investors would eagerly take every few months a 1 billion euro 5% bond from Vale. I don't think that issuing USD denominated debt would be a good idea since Vale would need to offer at least 12% in USD to sell it, making this very expensive.
With an average iron ore price of $45, then Vale will be cash flow neutral in 2016-2017 only needing to refinance the debt and in 2018 it would start making some serious money. At an average of $55 then we have a paradise on earth scenario: Vale can even cover its debt repayments without issuing new debt! And in 2018 it could even pay dividends.
So Vale is not in a comfortable position, but most likely it will survive. But what surprises me the most in all of this, is how absent Vale's management is. The company is in fatal danger, but they don't seem to care. One year ago, two years ago, they at least presented some plans, like asset sales and base metals IPO. Even if they failed to deliver, that was something. It showed that they see that things are bad and are working on a turn around. But now that the situation is ten times worse, they don't even propose anything. The image of Nero watching Rome burn comes to mind. Why don't they do something? Sell all coal assets even for a low price, just to stop the capital loss there. Instead of doing that, they calmly report every three months that another 400 millions in CAPEX and another $150 million in negative EBITDA went down the drain in the African operations, as if it made no difference. They need to wake up fast, before its too late.
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Nacala Corridor Railway in Mozambique. Source: aurecongroup.com
Many people talk about a „bottom", and maybe we finally reached it. But to actually see the price share go up instead of merely getting stuck at a low level, there needs to be some kind of concrete reason, some kind of corporate event to create upwards pressure. In the case of Vale I think that only an iron ore price above $55 would be enough to move the stock significantly higher. There will be no return to the bonanza years of dividends of $1 per share, not unless the iron ore prices doubles at the very least. With this in mind, I think that buying Vale at this point is a bet in the price of iron ore, and I am not confident enough to predict what price we will see in a few years. There is a real chance that the company will get stuck in a long fight for survival in a world flooding with iron ore. I see a better risk-reward in debt instead of equity. Vale's bonds mentioned in my previous article are now trading very low, paying a total 12% per year in interest, that's enough to make face the risk of a bankruptcy.
Disclosure: I am/we are long VALE.
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.