Why The Bifurcation Of Iron Ore Markets Is Bullish For Cleveland-Cliffs

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About: Cleveland-Cliffs Inc. (CLF)
by: James Duade
Summary

Cleveland-Cliffs has dropped approximately 10% in the past 5 trading days.

Cliffs drop appears to be related to analysts downgrades for iron ore pricing, and downgrades for an iron ore major Rio Tinto.

This article aims to explain why Rio (who is predominantly a low to mid grade iron ore producer) is different than Cliffs (who is a high grade pellet producer).

Structural changes in iron ore markets are leading to a bifurcation between high quality iron ore, and low to mid quality ores driven in part by the Paris Climate Agreement.

The horrific Vale dam collapse this past January, which has disrupted the supply of high quality ores and pellets, has further exacerbated this bifurcation.

Introduction

Recently a friend of mine asked me about the long term prospects of Cleveland-Cliffs (CLF) which has dropped nearly 10% in the past week (i.e., 3/4/19 - 3/8/19). Below is an article inspired by my response to him, which discusses why a structural change in iron ore markets is forcing market participants to pay a great deal more for high-quality iron ore relative to low-to-mid quality ores. This bifurcation in large part is being driven by environmental policies in China as a result of the Paris Agreement. This article at a high level will contrast Cliffs, who is a high-quality iron ore producer, against Rio Tinto (RIO), who is predominantly a low-to-mid quality producer of iron ore. As the reader will see, Cliffs is setup perfectly to benefit from the structural change bifurcating iron ore markets described below. Furthermore, the market imbalance caused by this structural change isn't likely to correct anytime soon, and will provide Cliffs with high margins on its pellets for the foreseeable future.

The Bifurcation of Iron Ore Markets: Cleveland-Cliffs vs. Rio Tinto

This past week, Cleveland-Cliffs opened at $10.85 on Monday, March 4th and closed on Friday March, 8th at $9.78, a drop of $1.07 or 9.86%. What was curious about this significant drop is the fact that Cliffs had no negative news released during this time frame, and in my opinion has no fundamental issues that would warrant such a drop. I think the volatility over the last week has been largely due to the fact that some major investment banks like UBS have lowered their forecast on iron ore prices for 2019, and also put a downgrade on Rio Tinto. If i had to guess I think that Cliffs is going down in sympathy and iron ore stocks are falling out of favor for a little while.

I think the above is just the broad market sentiment on iron ore since the proxy for the health of iron ore stocks is essentially the 62% Fe index (for better or worse). As the forecast goes up or down for 62% Fe fines, then the market will swing one way or the other - this seems to be the main reason, in my opinion, for the big drop in Cliffs stock price this week.

While I agree with UBS that iron ore prices based on the 62% IODEX fines will likely trend lower over the next year (probably finding a home around $70 - $75 in my opinion), I think the conversation needs to be a lot more nuanced than that. In my opinion it is appropriate to downgrade Rio Tinto based off of the 62% IODEX since Rio predominantly sells Direct Shipping Ore "DSO" iron ore that ranges from 60-62% from their Western Australian Pilbara mines (see figure 1 below). The notable exception to that is their Iron Ore Company of Canada holding which sells a 65% Fe concentrate and pellet product. Conversely, Cliffs sells an entirely different product (i.e., high-quality iron ore pellets around 60-65% Fe), that are priced very differently than the majority of Rio's ore, so it would be inappropriate to downgrade Cliffs on just the IODEX alone (see figure 2 below). To be clear UBS didn't downgrade Cliffs, but I think the market is essentially downgrading Cliffs because of the drop in 62% Fe forecasts.

Figure 1: Rio Tinto iron ore reserves, image taken from page 277 of Rio's 2018 annual report.

Figure 2: Cliffs iron ore reserves, image taken from page 36 of Cliffs 2018 annual report.

Furthermore, I think the market will eventually come to realize that the Vale (VALE) dam disaster has exacerbated an emerging trend, which is the bifurcation of iron ore markets. On one side you have low (58% Fe) and medium grade fines (62% Fe) that are used for sintering, and on the other side you have high-quality fines (65%Fe+) that are generally used as pellet feed. The low and medium grade fines predominantly come from Australia's Pilbara region, and these ores are generally sintered by steelmakers in China, and then fed into steel making blast furnaces. To appreciate this bifurcation it's critical to understand the difference between sintering and pelletizing.

The Environmental Impacts of Sintering vs. Pelletizing

The sintering process utilizes low-to-mid quality iron ore along with coking coal and fluxing agents in order to produce a product that can be fed into a steel making blast furnace. Unfortunately, sintering leads to a huge amount of pollution (see the article, and quote below from said article).

"Iron ore sintering is a material preparation process employed worldwide in the production of iron and steel. According to statistical data on pollution, sintering plants rank second in terms of toxic emissions, after the incineration of municipal solid waste (Menad et al., 2006; Remus et al., 2013). "

Section 18.1.1 of "Sintering emissions and their mitigation technologies" by L. Lu, et. al

As an alternative to sintering, iron ore can be pelletized. Pelletization was initially developed in the early to mid 1900's in Minnesota by E.W. Davis - the history is detailed in Pioneering with Taconite. The whole reason Pelletization came about was due to the fact that the United States' high grade iron ore deposits, particularly those in the Vermilion and Mesabi Ranges, were largely depleted by the mid 1900's leaving the United States without a strategic supply of iron ore to feed the country's growing need for steel.

While DSO supplies in the United States were being depleted rapidly - a process that is occurring in Australia and Brazil today - the Mesabi Range did have plentiful amounts of low grade iron ore in the form of Taconite which was approximately 30-20% Fe. E.W. Davis realized that Taconite's iron content could be liberated through a process of crushing and grinding the taconite, and then liberating the magnetite in the Taconite via magnetic separation. This process creates a high-quality iron ore concentrate that is generally 65% Fe+. Unfortunately, the concentrate is too fine to be fed directly into a blast furnace. Instead of being sintered like low grade DSO fines, the taconite concentrate can be pelletized by binding the concentrate with a bentonite binder, adding a fluxing agent like limestone or dolomite, and then finally the pellets are roasted which turns the magnetite to hematite via oxidation. In general low grade DSO ores are typically not pelletized because the pelletization process dilutes the iron content slightly (i.e., a 65% Fe concentrate may make a 63% Fe pellet). Ores that already 62% or lower would thus create an iron ore pellet that would have too low of an iron content to be effectively used in a blast furnace.

While the United States developed pelletizing out of necessity due to the depletion of high grade DSO ores, pelletization is superior to sintering low grade ores for a number of reasons. One major reason is that pelletizing is much better for the environment than sintering. As the below excerpt from this academic article indicates sintering emits 20 to 40 times more toxic particulate into the air than pelletizing.

"Sintering of ores emits up to about 5 kg/t of finished sinter, but after appropriate abatement maximum EU values in sinter strand waste gas are only about 750 g of dust per ton of sinter, and minima are only around 100 g/t, but there are also small quantities of heavy metals, with maxima less than 1 g/t of sinter and minima of less than 1 mg/t (Remus et al., 2013). In the United States, modern agglomeration processes (sintering and pelletizing) emit just 125 and up to 250 g of particulates per ton of enriched ore (USEPA, 2008)."

Energy costs and environmental impacts of iron and steel production, Vaclav Smil

In addition to the reduced pollution foot print that pellets have, pellets are also more efficient in blast furnaces than sinter. Pellets have a uniform size that is generally around 11 mm which allows gas to flow efficiently throughout a blast furnace. Conversely Sinter is often 25 mm or less in size, but the properties are not uniform like a pellet and sinter doesn't allow gas to flow through a blast furnace as efficiently. Furthermore, pellets melt at lower temperatures than sinter, and thus the steel maker will spend less on energy costs relative to sinter. If you're interested in a primer on the role of sinter vs. pellets in steel making, I recommend reading through chapter 3, of Modern Blast Furnace Iron Making: An Introduction.

Image from: Modern Blast Furnace Iron Making: An Introduction, pg. 20

Why Have Iron Markets Bifurcated Now

On July, 5th 2018 the Chinese government initiated the Three-Year Blue Skies policy that is to run through 2020. The goal of the policy is to significantly reduce the emission of harmful pollutants by steel makers in order to help the country comply with the Paris Agreement. The country intends to do this by curbing production at steel makers who have high pollutant emission rates, but allowing production at steel mills with low pollutant emission rates. As the above section indicated, pelletizing is 20 to 40 times cleaner than sintering, and thus steel makers are much more likely to seek out high-quality pellets (or pellet feed) in order to keep producing steel.

By the fall of 2018 the impact of this policy could be seen in exploding pellet premiums. While the contracted annual pellet premium was set at approximately $58 per ton, spot pellet prices in China in October of 2018 were around $80 (see previous link). Furthermore, the spread between 65%Fe and 62% Fe ore had ballooned out to over $27 a ton (see previous link).

While the exploding pellet premiums was of great interest to market participants, of equal or greater importance was the delta between 65% Fe and 62% Fe ore. Historically iron ore markets would price iron ore on a Dry Metric Ton Unit or "DMTU" basis. This means that if a ton of 62% Fe sold at $62, each DMTU was $1, so a ton of 65% Fe would be sold at $65. The difference between the 65% Fe product and the 62% Fe product was thus $3 or about 4.8% difference in price. However in October, 2018 when the 62% index was approximately $70 per ton, the 65% index was at approximately $92 per ton. Meaning a delta of around $27 per ton or a 38.6% difference!

Given the above, this has led an iron ore analysts at Platts to indicate that iron ore markets have gone through a structural change that is here to stay.

The Vale Dam Collapse Has Further Exacerbated this Bifurcation

On January, 25th the Corrego do Feijao mine in Brumadinho, Brazil collapsed and to date has been responsible for the death of at least 186 people, while another 122 are still missing. Compounding the problem for Vale is the fact that the Corrego do Feijao dam collapse came only three years after the horrific Samarco dam disaster, which stands as Brazil's worst environmental disaster to date. The two horrific dam collapses in close proximity to one another have caused an enormous amount of outrage from the Brazilian public, which has in turn forced the Brazilian government to take serious actions against the company. These actions including temporarily removing the Vale CEO, the closure of potentially 90 million tons of production, and $7 Billion in fines, just to name a few.

The potential long term impact of this dam disaster on iron ore markets is enormous. For starters, Vale is the world's largest iron ore producer, producing nearly 400 million tons of iron ore per year. Furthermore, Vale is also the world's largest producer of pellets and high-quality pellet feed. Shortly after the disaster, Vale shutdown approximately 40 million tons of iron ore production, of which 11 million tons would be pellets. According to this article on Bloomberg, this curtailment of production amounts to about 10% of Vale's overall annual output and about 3% of the global seaborne iron ore market - but amounts to about 8.5% of the global pellet market. Additionally, the Brazilian government shortly thereafter shutdown Vale's Brucutu mine which would likely lead to a further 10 million tons of pellets being taken off the market.

These events have rocked iron ore markets, and have taken spot iron ore prices for 62% Fe fines from approximately $70 before the collapse in January to a current price in the mid $80's. As of the writing of this article 62% Fe is trading at $85.77 and 65% is at $98.60. Furthermore, the Vale dam collapse has caused a panic in MENA pellet markets where Vale was a large supplier of pellets and DR grade pellets. A market participant in this S&P article summed it up as follows:

What was expected to have a peak impact of 40 million mt/year at the very most, and in staggered form, has already reached 90 million mt/year because of the government authority actions, which followed Vale's decision" to close the Paraopebas and Vargem Grande area mines, said one source. "What was expected to be an orderly plan has been extrapolated and now ore and pellets will go short. There's no way they can't go short.

What This Means for Iron Ore Investors

Investors would be wise to take note of the bifurcation of iron ore markets and invest accordingly. Companies like Rio Tinto that predominantly provide low or mid-grade iron ore products are likely to not benefit from this structural change in iron ore markets, however companies like Cliffs, which produces high-quality pellets are extremely well positioned to benefit.

Furthermore, as China and the rest of the world move towards stricter pollution standards - driven in part because of the Paris Agreement - the market for high-quality iron ore will only increase over time, while the market for low-to-mid grade ore will stagnate. This is one reason that several activist investors have asked Rio Tinto to reduce their risk to low-to-mid quality iron ore that is used in sintering:

Market Forces asset management campaigner Will van de Pol said Rio chief executive Jean-Sebastien Jacques had good reason to be concerned about the company’s reliance on iron ore. He said “This is a simple matter of risk management that Rio Tinto needs to undertake for its shareholders. If Rio faces risks from its exposure to a commodity that is structurally challenged by action on climate change, it needs to plot a course to minimize that risk.

Quote from Activists demand measures from Australian iron ore industry miners over steel emissions, published March 8th, 2019

Additionally, as recent events have indicated the market for pellets and high-quality iron ore concentrate is already in tight supply and these market dynamics are pushing up the premiums for 65% Fe fines as well as the pellet premium.

This trend will only grow stronger over time as the world starts to deplete its dwindling high grade DSO iron ore deposits - as mentioned previously this very scenario happened in the United States in the early 1900's - and forces market participants to concentrate lower grade ores like Taconite. While lower grade iron ore properties around the world are plentiful, these properties are generally in remote regions and take years to develop and billions of dollars in cap-ex to bring to market. In my opinion, a number of these projects will eventually come to market, but it could be 5-10 years before this occurs in a meaningful way. In the meantime companies like Cliffs, which have existing high-quality iron ore resources and pellet making capabilities are likely to experience high demand and high margins for their iron ore products until this market imbalance is corrected.

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.