Why Weakening Iron Ore Prices Should Not Deter Investors From Holding Vale

| About: Vale S.A. (VALE)

Summary

Iron ore was one of the worst-performing commodities in 2014.

Vale shares tumbled more than 46% last year as iron ore prices tumbled.

Despite the drop in prices, the Brazilian mining giant and its Australian rivals continue to ramp up production.

The recent decline in oil prices has significantly brought down Vale's transportation cost to China and given the company an advantage over its Australian rivals.

Oil was not the only commodity that saw a huge drop in 2014. Iron ore prices also fell sharply last year. Weighed down by a supply glut, softening demand from China and continuous production ramp-ups from large miners, prices plunged about 47% in 2014. That made the steelmaking ingredient one of the worst-performing commodities in 2014.

With the backdrop of falling prices, Brazilian iron ore giant Vale SA (NYSE:VALE) also felt the heat. The stock tumbled more than 46% last year. In fact, Vale was the worst performer among the three major iron ore mining companies, which include Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP).

The macroeconomic situation hasn't changed much so far. Commodities have remained under pressure since the start of this year, with oil prices crashing to multi-year low levels. Moreover, China, which accounts for about two-thirds of global sea-borne iron ore demand, is slowing. Still, Vale made a positive start to this year. A New Year rally was sparked after iron ore prices momentarily edged higher following a slight pull-up in demand from China. Demand improved as Chinese steel manufacturers were restocking inventories ahead of the Chinese New Year.

But iron ore prices quickly retreated as the demand eased, stoking concerns over a possible repeat of last year's dismal run. The concerns look very reasonable as the low-price environment will continue to put pressure on both top-line and bottom-line growth. Importantly, the low price environment is here to stay. But I have been bullish on Vale since last year. In fact, in an article written in September, I had discussed the reasons for my bullish stance. While the stock is down sharply since that article was published, I remain confident about Vale's prospects. If anything, the case for going long on Vale has become even stronger given the current price level and a factor that I had not considered in my article back in September.

China accounts for about two-thirds of the world's sea-borne iron ore consumption. Along with Australian giants Rio Tinto and BHP Billiton, Vale accounts for about 60% of global iron ore exports. For Vale, the encouraging news is that it is now emerging as the biggest supplier of iron ore to China. Thanks to a steep drop in oil prices, Vale now has a cost advantage over its rivals. Bloomberg citing Bernstein reported that in the last five years, the average cost for Vale to ship iron ore from Brazil to China stood at $23 per ton while for Australia it was $9 per ton. Now, however, amid sharp drop in fuel prices, Vale's iron ore shipping cost (mining cost included) to China is $6 per ton lower than that of Australian miners.

Not surprisingly, Brazil's iron ore exports have climbed sharply. Last month, Vale's iron ore shipments jumped 18% to 37.4 million tons from 31.8 million tons in the year-earlier period, the highest year-over-year growth recorded in last nine years, according to Bloomberg. Moreover, the prevailing low-price environment has driven out high-cost iron miners. According to Rio Tinto's estimates, sharp drop in iron ore prices cut global supplies by 125 million tons in 2014 as high-cost miners in China and other fringe producers such as Indonesia, Iran and Mexico found mining uneconomical. Both Rio Tinto and BHP Billiton expect that the supply cuts in the global sea-borne iron ore market will be even deeper in 2015, even though some might argue against it.

On the other hand, Vale is ramping-up production. In the fiscal third quarter, Vale produced 85.7 million tons of iron, which was the record production level in the mining company's history. For the three quarters of the current fiscal year, Vale has recorded production of 236.2 million tons- a growth of 8.1% over the year-earlier period. In 2015, Vales expects its output at 340 million tons, which also includes third-party procurements.

Against this backdrop, where high-cost miners are exiting and lower fuel costs are helping reduce freight cost, Vale's market share is likely to get a boost even as it increases its output. Earlier in January, UBS Group in its research note said that prevailing conditions (low oil price) will help Vale generate an additional $680 million in earnings (EBITDA) this year and $1.5 billion in 2016.

Of course, Vale will only have an advantage as long as oil prices remain at current levels. I had expected Brent crude oil prices to stabilize at around $60 per barrel last month; however, prices are now well below this level. Indeed, it seems as if prices are headed toward the level hit since after the financial crisis of 2008. The price decline has prompted some production cuts among U.S. producers, though so far it has not had any impact. However, these production cuts will eventually help in stabilizing prices. We are unlikely to see the days of $100 per barrel for a considerable period, and this means that Vale will continue to enjoy lower transportation costs.

Disclosure: The author is long VALE, BHP.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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