Good Quality Iron Ore And Low Cost Will Help Vale

Iron ore supply is expected to increase this year by miners like Rio Tinto (RIO) and Fortescue Metal Group (OTCQX:FSUGY). Rio plans to increase its annual production capacity to 290 million metric tons by the first half of this year from 266 million metric tons last year, and by 2015, the company expects to increase its annual production capacity to 330 million metric tons. Fortescue projects an annual production capacity of 155 million metric tons by March of this year, up by 40 million metric tons from last year. On one side, supply is increasing, while on the other, iron-ore demand in China, which accounts for about 65% of the world's seaborne iron-ore trade, is expected to grow at slower rate than last year. This year China's iron-ore import demand is expected to grow by 6.25% compared to 7.5% last year. With the decline in the demand growth rate and rise in production volume of these companies, iron-ore supply is expected to surpass iron-ore demand by the second quarter of this year.

Because of oversupply, iron-ore prices are expected to fall to $110 per metric ton by the end of this year and $90 per metric ton by end of 2015 from the current price of $122 per metric ton. Lower iron-ore spot prices will negatively affect revenues of all iron-ore miners.

The table below shows the importance of iron ore for three big miners -- Vale SA (VALE), Rio, and BHP Billiton (BHP) -- which together account for 59% of the global iron-ore trade.

Company	Iron ore contribution in EBITDA in 2012
Vale	90%
Rio Tinto	78%
BHP Billiton	46%

As Vale has maximum exposure to iron ore, low prices will affect its earnings more than other two. However, Vale has potential to do well, even in the low iron-ore price environment. The following factors will help the company to grow:

1. China is demanding higher grade iron ore

Last year, hazardous smog was seen in the China's many large cities, so the government asked steel producers to reduce emissions that cause air pollution. To lower emissions, the country's steel producers are buying higher-grade ore over low-grade ore. This initiative could cut rising export volumes from smaller exporting countries like Iran, Indonesia, and Mexico because of the higher sulfur content in their ores that generates higher levels of pollutants when it is removed during processing. Iron ore from these countries contains about1.5% to 2% sulfur, compared to Vale's sulfur content of just 0.05%.

Another advantage of Vale's ore is the higher iron content in it. Vale's iron ore from the Carajas region, where the company produced about 32% of its iron ore in first nine months of last year, contains 64% to 66% iron, compared to normal iron-ore fine product, which contains 62% iron. Vale also has an environmental license for the N4-E pit, which is part of Serra North iron-ore mining site at Carajas that will help it increase higher-grade iron ore production. This approval will help the company to meet its 2014 iron-ore production volume guidance of 312 metric tons, which is 2% higher than its 2013's production forecast.

In the spot market, ores with more than 62% iron content are selling at a premium of $17 to $18.6 per metric ton over the spot price, compared to a premium of $8 per metric ton six to seven months back. Meanwhile, iron pellets with 65% iron content are selling at premium of $40 to $42 per metric ton, up by $10 per metric ton from six month back. Along with the spot market, Vale is charging premium of about $4.5 per dry metric ton over the normal price formula it applies for carajas iron-ore long-term supply contracts with Chinese steelmakers.

Analysts expect higher premiums will remain for the full year, as China's government will continue emissions restrictions for steel industries. These restrictions will drive use of higher-grade iron ore, which will keep premiums high. With high quality iron ore, Vale's sales will increase, and higher premiums will help the company offset low spot prices.

2. Low cost will offset low iron-ore prices

The advantage with Vale is that it produces higher-quality iron ore at a lower cost. Excluding seaborne freight, Vale has to incur about $28 per metric ton of iron ore. However, the shipment cost is what affects the company's margin. Sixty Percent of Vale's total iron-ore volume is sold in Asian markets, and the company takes about 60 to 70 days to deliver the products to Asian clients. Shipment cost from Brazil to Asia is about $17 per metric ton compared to $7 per metric ton from Australia to Asia. However, even at high shipping costs Vale will generate good margins despite the drop in price.

To reduce the delivery time and shipment cost, Vale is developing the Teluk Rubiah Terminal, a distribution center and port in the state of Perak, in Malaysia, that is expected to be operational by October. The terminal consists of an iron-ore storage yard and marine terminal with annual handling capacity of 60 million metric tons. After construction of the storage yard, the company can stockpile iron ore in Malaysia and reduce its delivery time to Asian customers to less than 15 days -- one fourth of its current delivery time.

In addition, after the Malaysian terminal starts operation the company can anchor its Valemax vessels at the port and deliver iron ore to its Asian clients through smaller vessels. Valemax can deliver about 400,000 tons of iron ore in one trip, which is twice the large Capesize vessel's capacity of 180,000 tons. Valemax will cut the company's shipping cost per ton by one-third compared to the cost of delivering iron ore by smaller vessels. With lower production cost and expected reduction in shipment cost, the company is in good position to counter the potential decline in iron-ore prices.

Conclusion

Global iron-ore prices are expected to decline in coming quarters, which will hurt Vale's earnings. However, the company is in good position to retain its margin due to its higher-quality ore, which is produced at lower cost. With its overall growth prospects, I recommend investors buy the stock.

Source: Good Quality Iron Ore And Low Cost Will Help Vale

Disclosure: I 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. (More...)

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