Why Vale Can Still Rise Higher

| About: Vale S.A. (VALE)

Summary

Vale shares have pulled back in September as it is being anticipated that a possible supply increase of iron ore will create oversupply and hurt pricing.

However, demand for iron ore has remained robust due to positive developments in China and the trend will continue going forward, which is good news for Vale.

Chinese steel mills have maintained their output this year as infrastructure investments in the country will lead to an increase in demand for steel.

Since China’s iron ore output is slowing down, the country will need to import more iron ore going forward and Vale is ready to capitalize on this opportunity.

Vale’s S11D project will allow it to reduce costs by almost 25%, which will allow it to compete more effectively for Chinese exports.

The rally in iron ore prices has had a positive impact on Vale (NYSE:VALE) so far this year, with the stock gaining close to 70% in 2016. However, of late, Vale shares have pulled back a little as there are concerns that the price of iron ore will take a hit on account of oversupply going forward. In fact, it is anticipated that iron ore will go down from around $55/ton to $50 a ton going forward on the back of new supply coming online.

This has created weakness in iron ore pricing this month, creating a pullback at Vale. However, I think that the demand for iron ore will continue to remain strong going forward on the back of robust demand in countries such as India and China, and Vale will be well-placed to capitalize on the opportunity. Let's see why.

Demand for iron ore will remain robust

A key factor why iron ore prices have rallied in 2016 is because of strong demand from China. The country, which consumes around two-thirds of the global iron ore, has been importing large amounts of the commodity in order to boost steel output.

For instance, in the month of August, China imported 87.7 million tons of iron ore, which was almost flat from the imports of 88.4 million tons in the preceding month. What's more, China's iron ore imports for the first seven months of 2016 have increased around 10% from the prior-year period and it is anticipated that the country will import more than 1 billion tons of the commodity this year.

The strength in China's iron ore imports is a result of the rally in steel prices, which has boosted the country's steel mills. For instance, in the first eight months of 2016, China's steel output has remained flat from last year even though the government had announced late last year that there will be capacity cuts. As reported by Bloomberg:

The goal for this year was to cut capacity by 45 million tons. But by the end of July, the reductions were at 21 million, according to the National Development and Reform Commission, prompting calls for efforts to be accelerated. Some producers were reluctant to close mills because rising prices this year have boosted profits by more than 50 percent, according to Bloomberg Intelligence.

Thus, it is evident that steelmakers in China are taking advantage of higher steel pricing and this has kept iron ore demand strong. Another factor that has helped iron ore imports stay robust in China is the country's investments in infrastructure. China, for example, will be investing $720 billion in its transport infrastructure going forward, while $61 billion has been allocated for local infrastructure development.

As a result of these moves, more steel will be needed going forward as infrastructure needs to be developed. Also, since China's domestic iron ore output is expected to slow down, the country's imports will rise in the future. Over the past 10 years, China's iron ore output has increased at a CAGR of 13%, but this rate will go down to just 4% by 2020.

Hence, it won't be surprising to see China's iron ore imports remaining strong going forward, which will play a key role in mitigating any oversupply in the market.

Why Vale is well-placed to capitalize on the demand

Vale will be able to capitalize on the growing demand for iron ore in China due to its low cost operations. More specifically, the development of the S11D iron ore mine in Brazil will play a key role in reducing Vale's costs and allow it to export iron ore at competitive rates to China.

This is because the development of the S11D mine will allow Vale to reduce its overall cash cost of mining iron ore to under $10/ton. In comparison, at the end of the previous quarter, Vale's iron ore cash costs came in at $13.20/ton. This means that Vale will be able to reduce its iron ore cash costs by around 25% once the S11D project comes online.

Currently, the company has achieved 90% completion on this project and received a license for 10 years to build a railroad that will connect the mine to the Port of Ponta da Madeira from where exports will be made starting later this year. Hence, Vale's focus on developing this low cost asset will allow it to tap the demand in China at a competitive pricing going forward, which will allow it to increase sales and margins simultaneously.

Conclusion

Hence, investors should not get discouraged by the recent weakness in Vale shares since the fundamentals of the iron ore industry should continue holding up going forward. Additionally, the company will also benefit from its focus on low-cost operations, which will allow it to compete more effectively in the end market. So, in my opinion, it will be a good idea to remain long Vale shares going forward in light of the points discussed above.

Disclosure: I/we 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.