A Production Cut By Vale Could Eventually Increase The Price Of Iron Ore Again

Jan. 20, 2015 5:05 PM ETVale S.A. (VALE)18 Comments

Summary

  • Vale is the largest, but the least profitable, of the three major iron ore miners.
  • The group’s production plan forecasts an increase from 327 mmt (million metric tons) in 2014 to 453 mmt in 2018.
  • The quality and profitability of Vale’s assets is relatively inhomogeneous, which is an incentive to idle the least profitable ones.
  • A production cut by Vale could become a catalyst for the iron ore price and Vale’s margin could double after a price recovery.
  • I will describe a scenario of how and when this could actually happen.

Vale (NYSE:VALE) is and will remain the largest iron ore miner globally, according to its future production plan, with an estimated production volume of 327 mmt in 2014 that will increase to 453 mmt in 2018.

Source: Vale's investor presentation.

A supply glut combined with relatively weak demand from China has caused the iron ore price to drop by more than 40% in 2014. Together with the falling iron ore price, Vale's stock was beaten to new lows in the middle of December. It seems as if many investors have lost their last bit of confidence in Vale, but the time might be near to consider the stock again.

Is the Iron Ore Price Approaching the Bottom?

The iron ore price determines Vale's fate, and there are some signs that it could finally be approaching the bottom. At the current Platts CFR China price index level of around US$70/dmt (dry metric ton), the price has already reached a five-year-low, down from more than US$130/dmt one year earlier.

If this price level can be maintained seems somewhat questionable, since the larger iron ore miners continue to add more low-cost capacity but the further downside potential is limited. The pace of capacity growth could exceed the rate by which high cost supply is forced out of the market. Besides Vale, Rio Tinto (RIO) plans to raise capacity from 290 mmt in 2014 to 360 mmt in 2017, and BHP Billiton (BHP)(BBL) from 225 mmt to 290 mmt over the same period. A price of US$60 is forecast by some analysts and could supposedly be reached later in the year 2015, as additional capacity continues to enter the market.

This is bad news, but on the bright side the low-price environment forces the highest-cost iron ore miners to exit the market. Therefore, the leading iron ore miners should in fact not be interested in a fast recovery to levels that would ease the pressure on the high-cost producers too soon. The longer the price remains depressed, the more the non-competitive iron ore volume will disappear from the market. I anticipate that the ongoing market consolidation will require some time, at least until the end of 2015 or even well into 2016. I further assume that during this period an acceptable iron ore price for the majors like Vale stands somewhere between US$70 and $75, low enough to continuously weaken competition but high enough to stay profitable.

Ultimately, a recovery of the iron ore price can only be expected after the out-of-balance demand and supply situation improves. The quickest solution to this problem would be a production cut by the dominating iron ore exporters: Vale, Rio Tinto, and BHP.

Vale Could Become the First Major Iron Minor to Cut Production

At present, the three majors remain committed to their volume over price strategy, which increases their market shares and their combined market power. This leads to the questions why and for how long the leading players should continue to destroy margins by flooding the market. In fact, the simplest way for Vale and the others to leverage profitability would be to drive up prices again by mining less.

Vale and the other iron ore miners would benefit from a price recovery if they reduced the production volumes, but, currently, none of them is willing to make the first move. Vale's management has been asked whether the group considered cutting production at its recent investor conference and clearly denied it. Although this answer may very well be true today and throughout 2015, the situation could change not too far in the future after the ongoing shakeout comes to its end.

Although it might seem a little far-fetched at the moment, Vale could become the first iron ore miner to start reducing its production volume in the mid-term. Good timing would be once the additional capacity from its new low-cost S11D mine comes onstream in 2016.

Why should Vale by the first one to cut production? First, Vale has the largest capacity and could most easily cut some of it. Second, compared to its Australian competitors Rio Tinto, BHP, and Fortescue Metals Group (which mines its iron ore in the Pilbara region in Australia) the quality of Vale's iron ore and the costs of its operations are relatively inhomogeneous. Vale has several assets that differ in iron content and production costs. It could cut production at the highest-cost mines, which are probably not even profitable at today's price level.

Third, Vale has the highest costs delivered to China and the lowest margins and would consequently benefit the most from an increase of iron ore prices. Finally, Vale has the weakest balance sheet and the highest debt, but still the highest capital requirements in order to finalize its expansion projects.

How Could Vale Cut Production?

Vale's major assets in Brazil are subdivided geographically into three sectors: the Northern System, the Southern System, and the Southeastern Systems. The latter two consist of three major mining sites with several mines in each of them, whereas the Northern system can be considered as one large site that is divided into three main mining areas.

The quality of the iron ore from the different systems varies, and the Northern System has the highest grade hematite iron ore with an iron content of 66%-67%. The ore in the other systems is of lower quality, composed of the mineral itabirite with an iron content of only 35%-60% that requires further concentration -- which increases production costs. A further disadvantage is that the realized prices for these grades are lower. The different grades are blended to give a better and more constant quality, but overall Vale's realized average price remains below the 62% Platts reference index.

Vale's Production Overview Q3 2014

Source: Vale's Q3 2014 Production Report.

Today, the production volumes for the three systems do not differ significantly, but this situation will change. Vale's major investment projects target mainly the expansion of the Northern System, starting with the opening of the new N4W south pit, a project that has been recently realized after the operating license was obtained in November 2014. Besides an increased volume and economies of scale, a positive effect on cash production costs is expected, since the partly idle capacity of an existing crusher will be utilized. Additionally, the new pit will reduce transportation costs as it is located closer to the processing plant.

The single most important project for Vale is the new S11D mine, also located in the Northern System. This new asset will increase the company's capacity by 90 mmt after reaching full capacity in 2018, and the production will start ramping up in the second half of 2016. The S11D operation will become Vale's lowest cost production with anticipated cash costs of only US$11/ton at the port, including royalties. This compares to 2014 cash costs for the Northern System of US$21.2/ton and of US$24.5/ton for the Southern and US$20.9/ton for the Southeastern System. It is obvious that after the ramp-up of S11D, the overall costs of the Northern System will become the lowest and that the Southern System falls behind the other operations. For 2018 Vale expects cash costs of US$16.9 for the Northern, US$23.5 for the Southern, and US$20.1 for the Southeastern System.

The concept of lowering production costs by increasing production in the Northern System together with higher volumes of superior grade iron ore which can be sold at a higher price is very appealing, as it helps to partly offset Vale's biggest disadvantage -- the higher transportation costs to China. From a production cost point of view, the competitiveness of all Vale operations is already excellent. In comparison, the current cost leader among the major miners Rio Tinto reported cash production costs of US$20.4/ton in the first half of 2014 -- excluding royalties. But the disadvantage of having significantly higher transportation costs to China makes Vale the lowest margin producer among the big three.

Vale could reduce average production costs even further if it cut production at the highest-cost assets. Obviously, if Vale was looking for operations to idle and capacity to reduce, it would make sense to start with the Southern or the Southeastern System. As each of these systems consist of three sites with nine (Southern) and eight (Southeastern) operating mines of different ages and varying degree of automation, the production costs are differing. By cutting production at the highest cost pits, Vale could surely reduce the overall average cash production costs beyond the target that was already announced.

Thinking about the possible timing of a production cut, 2016 or 2017 -- which mark the years with the highest annual production increases of 36 mmt and 35 mmt -- would be a good starting point. This time frame coincides with the ramp-up phase of S11D. One possible scenario is the announcement of a capacity reduction in early 2016, sending a signal to the market and giving Vale some lead time before executing the program later in the year. An advantage of this timing would be that the bottom-line impact for Vale would be optimized as the most expensive iron ore was replaced by the cheapest production coming onstream.

In order to bring the iron ore price back into the eighties or nineties, a production cut would have to be substantial. I assume that at least 100 mmt of capacity had to disappear, which is too much for Vale alone. This means that for this strategy to work out, after Vale's initial move the others have to follow and to cut production as well. It also bears a risk for Vale as it cannot be foreseen what the reaction of its competitors would be. Basically, the others have two options: Keeping their capacity up or even try to gain market share at Vale's expense or to cut production as well. For me, the latter option is the most rational and likeliest as it could bring back their margins back to the levels before the supply glut.

Again, to be the first to cut capacity is a risky move as one cannot be sure that the others will follow, but by getting the timing right, this risk can be minimized. In 2016 or 2017, Vale could eliminate around 35 mmt or (approximately 10% of its total capacity) in its oldest and least productive mines while ramping up production in the new and more profitable operations. The overall production volume would remain constant and overall margins should at least remain stable.

If Vale was eliminating around 35 mmt tons of capacity (more or less the volume that is expected to be added in the years 2016 and 2017) or approximately 10% of its annual production, it would be a clear commitment. Assuming that the other major miners follow Vale's example and cut their production volumes at similar rates, all together 100 mmt could disappear from the market. That should clearly be seen as a catalyst to lift the iron ore price again as well as the stocks of iron ore miners.

Vale's Financial Performance

Vale is the least profitable of the major iron ore miners because of the highest transportation costs to China. Like any other of its competitors, Vale is trying to optimize costs and increase productivity. At the recent investor events, Vale detailed its plans to increase the EBITDA margin in 2018 by US$10 per ton by reducing production costs (minus US$4.00), cutting expenses (minus US$1.50), lowering freight costs (minus US$2.00) and realizing higher prices because of better quality (plus US$2.50). As a result, the overall costs delivered to China before depreciation in 2018 are estimated at US$45/dmt.

Since Vale's costs are US$10/ton higher today, the total costs of iron ore stand at US$55/dmt before depreciation on a CFR basis to China. This gives Vale not much more than a 20% EBITDA margin potential at the current benchmark iron ore price of US$70/dmt. If the price falls to US$60/dmt, Vale is barely breaking even.

It is obvious that given the huge production volumes, each dollar of cost reduction or higher price realization has a significant impact on Vale's profitability. For each dollar the iron ore price rises, Vale's EBITDA grows by approximately US$350M. Assuming that the scenario described earlier becomes a reality, the major iron ore minors all cut their production, and the price goes up to US$85 or US$90 from the current US$70 level, this corresponds to a price hike between 20% and 30%. For Vale it meant that the EBITDA could easily double or grow by US$5B and US$7B in absolute terms. If this really happens, the upside potential for Vale's share is huge.

Vale's share performance in the last five years has been abyssal and the stock has lost more than two-thirds of its value. By the middle of December 2014, Vale reached a low at US$6.82, but has recovered from that level by gaining more than 20% until today.

VALE Chart

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VALE Chart

VALE data by YCharts

What the rest of the year will bring for Vale is very difficult to predict. Giving the market volatility, particularly in the commodity sector and in emerging markets, anything seems to be possible. The share price could easily approach its December low or drop even further, but in my opinion the worst is over for Vale and the formation of a bottom could be near.

I have initiated a first position that I expect to increase over the next 12 months. In my view, Vale has become one of the badly beaten and unwanted stocks with a promising reward potential over a three- to five-year investment horizon.

Conclusion

Vale has deeply disappointed many investors in recent years, and I doubt that already 2015 will bring substantial gains from the current depressed share price level. However, the bottom for Vale could be close or it might have been reached already. I have tried to picture one possible scenario that could bring iron ore prices up again significantly in the mid-term. In the case of a substantial recovery of the iron ore price, Vale should be among the iron ore miners with the highest leverage to profit from this development.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation, any material in this article should be considered general information, and not relied on as a formal investment recommendation. Before making any investment decisions, investors should also use other sources of information, draw their own conclusions, and consider seeking advice from a broker or financial advisor.

This article was written by

My job has nothing to do with the financial world, on the contrary - I have a college education and a Ph.D. in science and I work for a large cooperation in the German industry. I bought my first stocks almost 20 years ago, starting with investments in DAX companies (the German large cap index) and have continuously broadened my horizon geographically and to other equity classes since then. My main ambition is to obtain financial independence and the admittedly challenging ultimate goal is to retire at the age of 50 (or at least in the mid-fifties). Let’s see how this turns out…
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Disclosure: The author is long BBL, RIO, VALE. 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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