In my latest article on Cliffs Natural Resources (NYSE:CLF), I stated that, perhaps, the multi-year destruction of value has finally convinced the majors to make a serious shift in their policies and forget the "lower end of the cost curve" mantra. Recent statements by Vale (NYSE:VALE) show that such conclusions are premature.
Talking about the cost curve again
Vale has just stated that the recent run-up in iron ore price was not justified by fundamentals. The company also predicted that low cost supply will increase. In addition, Vale reiterated its strategy that brought its shares to the current depressed levels: "We're prepared to operate at any price level because we'll be on the left side of the curve."
First, I don't know why the major iron ore miner would want to publicly make a bearish call on iron ore. This makes no sense to me, as Vale's comments clearly influence markets. This could have made sense if Vale had some very attractive takeover candidate on the watch list and wanted to get the best possible price for it. I doubt that there is such an unknown candidate for the company of Vale's caliber and that the company really needs any new projects.
Second, we are back to the "left side" arguments. The purpose of business is to make profit and reward shareholders. This could be done via share price appreciation, dividends or a combination of both. Simply being lower-cost producer does no good for shareholders if the supposed cost advantage does not translate into profits and share price growth. Recent years clearly showed that the damage done by the decrease in the price of iron ore cannot be healed by cost decreases.
Vale's first-quarter cash cost was $12.3 per ton of iron ore. Will the company ultimately push costs to $10 per ton? This is possible, with S11D at full production and some help from the Brazilian real. However, all the hard work is easily wiped out by what is a normal daily fluctuation of the iron ore price. Freight costs also won't go to zero. All in all, the logic was dead wrong at the beginning, the real world results showed it was wrong both in the company's financial report and the stock market, but for some reason the company's management sticks to the previous strategy.
Will iron ore return to previous lows?
The futures market indicates that we may be living in the $40 iron ore world soon.
As always, the main focus will be on China. I previously expressed my concerns with the fact that China evaporated from news when commodity equities were rallying. I doubt that China has a magic wand which could cure all the problems in a matter of months.
Recently, China's official PMI came just above 50, while the unofficial version showed contraction. All of a sudden, the country was in the news again, contributing to the plunge in iron ore and copper. In my view, the iron ore market cannot count on some major help from China.
Chinese authorities already indicated that they won't tolerate excessive speculative activity. On the fundamental front, it is unclear whether the country will start a significant number of infrastructure projects to help growth. So far, manufacturing numbers tell us that China is not out of the woods yet.
I am not predicting any kind of a "hard landing" - I currently don't see data which supports this - but some stagnation in commodity demand is surely possible. In this light, iron ore prices will depend on the ability of the supply side to adapt to new circumstances. This is where the suppliers failed consistently over the last years.
New comments by Vale indicate that the lesson was not learned. Sure enough, the company cannot stop the S11D project, which will contribute 30 million-40 million tons in 2017. According to the company's comments, this number will increase to 72 million tons in 2018 and to 90 million tons in 2019. This is a significant number for the market to digest.
Vale could have tried to implement strategy similar to the one that Potash Corp. (NYSE:POT) did to defend the prices in the potash market - relocate the production from higher-cost mines to the new S11D while keeping the overall production flat. However, given the active marketing of the "low cost" agenda, such a maneuver may not be realized in practice. I have to admit that Potash Corp.'s decision did not stop the fall of the potash prices, but potash market started from a different point and cannot be directly compared to the iron ore market.
Vale is following the same strategy that sent its stock to trade near $2 at the beginning of this year. As always, the only hope is that the "right end of the cost curve" will capitulate and supply will adjust. So far, we did not see this happen. Maybe, the iron ore needs another visit to $40 to knock out weaker producers. Goldman's call for $35 per ton of iron ore in the fourth quarter has a chance to turn into reality if reckless production policy combined with reckless public statements continue.
Disclosure: I am/we are long CLF.
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.