Cliffs’ Earnings Preview: Lower Iron Ore and Coal Prices Will Weigh on Results

Cliffs Natural Resources (NYSE:CLF) is expected to announce its second quarter results some time next week. We expect lower iron ore and metallurgical coal prices to negatively impact Cliffs’ quarterly results year-over-year. ((Iron ore spot price chart, Y Charts))

The company has taken various steps in order to operate competitively in a subdued iron ore and coal pricing environment. These steps have included idling of high-cost mines as well as adopting a strategy of disciplined capital allocation. In addition, the ongoing tussle between the company management and Casablanca Capital, an activist hedge fund that holds a 5.2% stake in Cliffs, will potentially end at the company’s annual meeting of shareholders, scheduled to be held on July 29. The outcome of this tussle is important from the point of view of the company’s strategic direction going forward.

See our complete analysis for Cliffs Natural Resources

Iron Ore and Coal Prices

Iron ore and metallurgical coal are important raw materials for the steel industry. Thus, demand for these raw materials by the steel industry plays a major role in determining their prices. Though a majority of Cliffs’ iron ore sales are to the North American steel industry, sales agreements are benchmarked to international iron ore prices. International iron ore prices are largely determined by Chinese demand since China is the largest consumer of iron ore in the world. It accounts for more than 60% of the seaborne iron ore trade. ^[1] Flagging demand for iron ore from China in the wake of an economic slowdown has put downward pressure on iron ore prices. According to data from China’s National Bureau of Statistics, growth in investment, factory output and retail sales has slowed to multi-year lows in the first two months of the year. ^[2] A Chinese government crackdown on polluting steel plants has forced many of them to shut down. In addition, tightening of credit by Chinese banks to steel mills that are not performing well, will negatively impact these mills’ prospects. ^[3] Furthermore, the Chinese leadership has proposed structural reforms of the economy, shifting the emphasis from investment and export driven growth to services and consumption led growth. Such a transformation of the Chinese economy may negatively impact Chinese demand for steel in the long term. Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. ^[4] Weak demand for steel has indirectly resulted in weak demand for iron ore as well as metallurgical coal.

On the supply side for iron ore, expansion in production by majors such as Rio Tinto and BHP Billiton has created an oversupply situation. A combination of weak demand and oversupply is likely to result in lower iron ore prices in the near term. Lower iron ore prices will impact Cliffs much more than the major mining companies due to the company’s higher cost of production of around $70 per ton, as compared to less than $50 per ton for Rio Tinto and BHP. ^[5]

Iron ore spot prices stood at $92.74 per dry metric ton (dmt) at the end of June 2014, about 19.2% lower than a year ago. ((Iron Ore Spot Price Chart, YCharts)) The outlook on iron ore prices remains bleak in the near term, in view of the oversupply situation.

China is also the largest consumer of metallurgical coal in the world. Demand for the commodity by the Chinese steelmaking industry has been weak, adding to subdued demand from other major consumers such as Japan and the EU. Weak demand coupled with an oversupply situation due to expansion in production by major mining companies, has resulted in plummeting coal prices. ^[6] This will have a negative impact on Cliffs’ North American coal business, which primarily sells metallurgical coal, whose prices are linked to prices of Australian metallurgical coal. Prevailing coal prices are around a third of their 2011 peak levels of $330 per ton. ^[7]

Cliffs’ Response

In order to remain competitive in a subdued iron ore and coal pricing environment, Cliffs has cut costs as well as adopted a strategy of disciplined capital allocation. The company has idled some of its higher cost assets in view of low iron ore prices. The Point Noire pellet plant was idled in 2013 and the Wabush mine was idled at the end of Q1 2014. Further, the company suspended the planned Phase 2 expansion at its Bloom Lake operations. ^[8] The company recently announced the sale of an exploration camp which is a part of its suspended Chromite project in Ontario. ((Noront Acquires Cliffs’ Chromite Ontario Exploration Camp And Receives Mining Lease Approval, Noront Resources Press Release)) It also announced its intention to temporarily idle its Pinnacle coal mine, as a result of the poor market conditions for metallurgical coal. ((Cliffs Natural Resources 8-K, SEC)) These are attempts to free up capital and deploy it into projects that generate greater value for the company.

The company has reduced its planned capital expenditure for 2014. The full-year capital expenditure range for 2014 is now expected to be $275-$325 million, around $100 million lower than its original guidance of $375-425 million, and approximately 65% lower year-over-year. Around 75% of the planned reductions in capital expenditure will impact the company’s high-cost Eastern Canadian Iron Ore operations and North American Coal operations. ((Cliffs Natural Resources Inc. Reduces Full-Year 2014 Capital Expenditures by an Additional $100 Million, Cliffs Natural News Release))

Casablanca Capital

In addition to the troubles caused by falling commodity prices, Cliffs’ negotiations with Casablanca Capital have resulted in a stalemate. Casablanca favors strategic focus on Cliffs’ U.S. Iron Ore operations and the sale of its Canadian and Asia-Pacific businesses. Cliffs’ management believes selling off these assets in a low commodity price cycle would destroy shareholder value. ^[9]  Negotiations between Cliffs and Casablanca over the number of Casablanca’s nominees on Cliffs’ board of directors have not resulted in an agreement. Casablanca is seeking election of six of its nominees to Cliffs’ eleven-member board at the company’s annual meeting of shareholders. ^[10] The outcome of this tussle between Cliffs’ management and Casablanca may impact the company’s strategy going forward.

Expectations from Conference Call

With the subdued iron ore and coal pricing environment set to continue in the near term, we would like to know whether the company has identified any other opportunities for reductions in operating costs or capital expenditure. We would also like the company’s management to give updates on its battle with Casablanca Capital. More clarity on this front will shed some light on the road ahead for Cliffs.

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1. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg [↩]
2. China Premier Warns On Economic Slowdown As Data Fans Stimulus Talk, Reuters [↩]
3. The Latest Iron Ore Price Slump: Causes and Effects, Forbes [↩]
4. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association [↩]
5. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb [↩]
6. Coking coal price crashes through $100, Mining.com [↩]
7. Pain of low coal prices finally too much for Australian miners, Reuters [↩]
8. Cliffs Natural Resources 2013 10-K, SEC [↩]
9. Cliffs Natural Resources Inc. Mails Open Letter to Shareholders, Cliffs Natural News Release [↩]
10. Casablanca Capital Files Definitive Proxy Statement and Sends Letter to Cliffs’ Shareholders, Wall Street Journal [↩]