Bleak Prospects For Cliffs Natural Resources In Low Iron Ore Pricing Environment

Cliffs Natural Resources (NYSE:CLF) has recently seen a change in management after activist hedge fund Casablanca Capital won control of the board of directors in a proxy contest. ^[1] The change of guard at the top included the appointment of Casablanca Capital’s nominee, Lourenco Goncalves, to the positions of chairman, president and chief executive officer. In order to boost the company’s prospects, the new management had indicated its preference for a business strategy focused on the company’s U.S. Iron Ore segment and the potential sale of its other mining operations, which comprise of the Eastern Canadian Iron Ore, Asia Pacific Iron Ore and North American Coal business segments . ((Miner Cliffs names Goncalves CEO, cancels coal mine plan, Reuters)) However, around two months post the change in management control, Cliffs’ stock price has declined nearly 35%. ^[2] This has largely been due to poor market conditions for both iron ore and metallurgical coal, Cliffs’ primary offerings. In this article, we look at the factors influencing Cliffs’ prospects in the near term and the road ahead for the company.

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Iron Ore and Coal Prices

The major cause of the company’s woes pertains to the weak prevailing environment for both iron ore and metallurgical coal. Both iron ore and metallurgical coal are major inputs in steel making and demand for these commodities is to a large extent correlated with demand for steel. 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. ^[3] However, Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. ^[4] A slowdown in economic growth has tempered the demand for steel. China’s GDP growth is expected to slow to 7.3% and 7.1% in 2014 and 2015 respectively, from 7.7% in 2013. ^[5] Further, 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. ^[6] 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. Weak demand for steel has translated into weak demand for iron ore as well.

On the supply side for iron ore, expansion in production by majors such as Rio Tinto and BHP Billiton despite weak Chinese demand, 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 iron ore 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. ^{[7] [8]}  Iron ore prices stood at $92.61 per dry metric ton (dmt) at the end of last month, around 32% lower than at the corresponding point of time last year. ^[9]

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. ^[10] 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. The benchmark price for Australian metallurgical coal stands at $119 per ton, around a third of its 2011 peak level of $330 per ton. ^[11]

Impact on Cliffs

In the context of the prevailing environment of low iron ore and coal prices, the company’s new management has an extremely tough job on its hands. The company will struggle to find buyers for its iron ore or coal assets, given oversupplied markets for both commodities and weak demand conditions. Further, the company may not realize the best value for its mining assets, even if some sales were to materialize. Moreover, as the company is looking to sell some of its high cost mining assets, it has to keep operating these mines, instead of idling them in response to poor market conditions. The new management has reversed the decision of the former management to idle the Pinnacle coal mine, if market conditions do not improve. The reason given for this decision is to ‘facilitate unlocking the value of assets’. ^[12] Thus, in its search for buyers for its mines, the company is forced to operate loss making assets. The North American Coal segment, which includes the Pinnacle coal mine, reported an operating loss in Q2 2014. Sales margin for the segment fell to a loss of $25.89 per ton in Q2 2014, as against a profit of $3.16 per ton in the corresponding period last year. ((Cliffs’ Q2 2014 10-Q, SEC)) Thus, the company is operating unprofitable mining operations for which finding buyers will prove extremely difficult under current market conditions.

The new management has recently amended the terms of its debt agreements in order to allow for a $200 million share buyback program. ^[13] This is indicative of a lack of investment alternatives for the company. The company has already curtailed its full-year capital expenditure for 2014 to $275-$325 million, approximately 65% lower year-over-year, in order to conserve cash. ^[14] Also, with the company’s stock price mirroring the decline in iron ore prices, Cliffs may also be looking to capitalize on an opportunity to buy back its stock on the cheap. However, there is little else the company management can do, apart from maintaining the company’s disciplined approach to capital allocation and looking for buyers for some of its high cost assets. Unless the iron ore pricing environment improves, Cliffs may be in for a rough time. With an oversupply situation and a low iron ore pricing environment expected to continue in 2015, the situation is looking grim at the moment for Cliffs. ^[15]

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1. Cliffs Natural Resources Inc. Announces Results of Annual General Meeting of Shareholders, Wall Street Journal [↩]
2. Cliffs Natural Resources Stock Price, Google Finance [↩]
3. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg [↩]
4. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association [↩]
5. Goldman Sachs cuts China growth forecast sharply, Market Watch [↩]
6. The Latest Iron Ore Price Slump: Causes and Effects, Forbes [↩]
7. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb [↩]
8. Cliffs Natural Resources’ 2013 10-K, SEC [↩]
9. Iron Ore Spot Prices, Y Charts [↩]
10. Coking coal price crashes through $100, Mining.com [↩]
11. Metallurgical Coal at 6-Year Low as Chinese Demand Slows, Bloomberg [↩]
12. Cliffs Natural Resources 8-K, SEC [↩]
13. Cliffs Natural Resources Inc. Amended Revolving Credit Facility to Allow for $200 Million Share Repurchase Program, Cliffs Natural Resources News Release [↩]
14. Cliffs Natural Resources Inc. Reduces Full-Year 2014 Capital Expenditures by an Additional $100 Million, Cliffs Natural News Release [↩]
15. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg [↩]