We've been writing a lot lately about global trade in general and mining in particular. Cleveland-Cliffs (CLF) is another mining company that comes to mind. As you can see from the weekly chart, there is no evaluation line. This is due in part to incomplete historical data in our database. The fact that the chart is color coded (metals & mining sector blue) means that we do follow CLF. Hopefully we will have a stock evaluation line up in 2008.
Even so, there are several items that need to be said. First, CLF closed at $103.61 on Friday and may have gotten a bit ahead of itself. Take into account that this article is being written on a $95 valuation. Second, the time frame is for 12 months forward.
For two decades, the steel industry was in the outhouse. As China's economy started to take-off, the Chinese expanded their steel industry in order to meet anticipated local demand. At first, China had an over capacity and was exporting cheap finished and semi finished products to the U.S. The outcome was depressed prices for raw materials by U.S. producers. In or about 2000, Chinese steel consumption started to increase rapidly. China further increased production capacity however the chronic U.S. and global overcapacity that existed beforehand dwindled, with the help of a few consolidations as well. This changed both the pricing and demand for raw material.
The advent of the mini-mills changed the landscape as well. In 2006, mini-mills produced 55 million tons of steel in comparison with the large integrated mills that produced only 45 million tons (figures are approximations).
As the largest U.S. producer of iron ore pellets (used in blast furnaces for steel production) the turn around was long awaited by CLF. However, there were several pitfalls that CLF had to address, the most urgent being a technological upgrade enabling CLF to supply mini-mill manufacturers. The shift in technology favored by the mini-mills is towards pig iron. Iron pellets used in electric arc furnaces need to be of a much higher purity. Trending away from blast furnaces appears to be gaining momentum, though it is beyond our capability to determine the cut-off point.
Technology and Diversification
To address the above, CLF entered into a ten year contract with Kobe Steel Ltd. (Japan). Kobe has licensed its pellet technology to be implemented in a new manufacturing facility, scheduled to come on line in 2010. The Michigan based facility should be able to produce a half million tons of high grade pellets equaling 10% of U.S. mini-mill raw material consumption.
CLF, remembering the lean decades, decided that it would use the current prosperity to diversify without venturing to far a field. The most recent acquisition in June 2007 was PinnOak, a U.S. coal property. The metallurgic coal comes from three mines in West Virginia and an additional mine in Adger Alabama, producing a combined seven million tons per year. There are approximately 140 million tons of proven reserves. The Adger Alabama operation produces a high grade coking coal that is enjoying the overall pent-up demand for steel.
The first leg of the diversification program was the acquisition of iron ore assets in Australia and Brazil and coal assets in Australia. Currently CLF possesses six iron ore mines in the U.S. and Canada, four coal mines in West Virginia and Alabama, an 80% ownership of Portman Limited (Australian iron ore), a 30% percent stake in Amapa (Brazilian iron ore) and a 45% stake in Sonoma (Australian thermal coal ).
Know Thy Coal
Enough of a background. The primary reason that we are writing this article now is to clear up a common misconception amongst investors. The graphics and charts below are public domain from the EIA (Energy Information Administration, U.S. government) as of 10/10/2007.
From the above chart, many conclude that coal has not returned to its 2005/6 highs. Now look below…
One must differentiate between thermal/high Btu/steaming coal and coking/metallurgic coal. The former is used for electricity and the latter is used in the steel industry. Need we spell this out?
The Price of Iron
There was a rift between analysts as to which way iron was heading. In October 2006 Credit Suisse Group, Daiwa Securities, Goldman Sachs and JPMorgan all predicted a 5% to 10% increase in iron ore prices for 2007 and a softening in 2008. In April 2007, Merrill Lynch broke with the consensus and predicted that iron ore prices would increase by 30% over the remainder of 2007 and 2008. By September 2007, the consensus saw things the Merrill way.
As China increases its iron ore imports, exceeding 330 million tons, we are inclined to agree with Merrill Lynch and then some. It appears to us that global steel production is heading towards breaking new records. India supplies 25% (+/-) of China's imported demand yet may not be able to increase production sufficiently in a timely manor for 2008. This will spark another round of contract increases.
A risk to our assessment for CLF (not the price of iron) is that current Australian port infrastructure may not be capable of handling much more volume without upgrading. This could take two years, postponing further benefits from the Australian acquisitions.
Should both iron ore and coking coal live up to predictions, we could see CLF trading at $160 in 2008.Disclosure: No conflicts.