Lower Iron Ore And Coal Prices Weigh On Cliffs’ Q3 Results

Cliffs Natural Resources (NYSE:CLF) released its third quarter results on October 27 and conducted a conference call with analysts on October 28. As expected, the company’s results were negatively impacted by lower realized iron ore and coal prices. Cliffs’ third quarter revenue stood at $1.3 billion, around 16% or $248 million lower than its revenue in the corresponding period a year ago.  The decline in revenue was due to a 32% reduction in market pricing for iron ore and a 17% reduction in market pricing for metallurgical coal, offset by higher volumes. ^[1] The company reported a $5.7 billion impairment charge pertaining to the assets of its Eastern Canadian Iron Ore, Asia Pacific Iron Ore and North American Coal operations. ^[1] The impairment charge is largely due to Cliffs’ revised outlook for long-term pricing trends and the adverse market conditions for seaborne iron ore and metallurgical coal. ^[2] Excluding impairment and other one-time charges, the company reported an adjusted net income of $33 million, as compared to an adjusted net income of $144 million in Q3 2013. ^[1]

The company maintained its lower capital expenditure guidance for the year, after it had slashed its expected capital expenditure for 2014 in May. The management commented upon the state of its Bloom Lake mine in Canada. It stated that the ongoing Phase I operations at Bloom Lake are not feasible, and it would continue to operate the mine in 2015 only if it could find equity investors for Phase II expansion. ^[3]

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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. ^[4] Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. ^[5] Weak demand for steel has indirectly resulted in weak demand for iron ore.

On the supply side, 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. ^[6] Iron ore prices stood at $82.38 per dry metric ton (dmt) at the end of September, around 38% lower than at the corresponding point of time last year. ^[7] As per Goldman Sachs, the worldwide surplus of seaborne iron ore supply will rise to 175 million tons in 2015, from an expected 72 million tons for 2014 and 14 million tons for 2013. ^[8] In view of the persisting oversupply situation, iron ore prices will remain subdued in the near term.

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. ^[9] 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 Australian metallurgical coal price stands at around $119 per ton, around a third of its 2011 peak level of $330 per ton. ^[10] In view of the oversupply situation, metallurgical coal pricing is expected to remain subdued.

Segment-wise Performance

Shipments for the U.S. Iron Ore operations rose from 6.29 million tons in Q3 2013 to 6.85 million tons in Q3 2014, primarily driven by an additional supply contract in 2014 and higher shipments to customers that had been affected by the freeze on the Great Lakes in Q1. The sales margin, a measure of segment operating income reported by the company, fell from $43.52 per ton in Q3 2013 to $32.05 per ton in Q3 2014 for the U.S. Iron Ore operations. This was primarily because of a fall in realized prices from $112.67 per ton in Q3 2013 to $100.70 per ton in Q3 2014. The fall in realized prices for the company’s U.S. Iron Ore operations was lesser than the corresponding fall in spot prices, as contracts for this division are mostly structured on 12-month averages. ^[1]

Shipments for the Eastern Canadian Iron Ore operations fell from 2.6 million tons in Q3 2013 to 2.28 million tons in Q3 2014, primarily due to lower shipments from the Wabush mine, which was idled in Q1. Shipments from Wabush stood at 700,000 tons in Q3, as compared to 1.2 million tons in the corresponding period last year. Sales margin for the segment fell from a loss of $14.72 per ton in Q3 2013 to a loss of $35.39 per ton in Q3 2014. This was primarily because of a fall in realized prices from $106.58 per ton in Q3 2013 to $70.91 per ton in Q3 2014. ^[1]

Shipments for the Asia Pacific Iron Ore operations rose from 2.77 million tons in Q3 2013 to 3.08 million tons in Q3 2014, primarily due to the favorable timing of shipments. Sales margin for the segment fell from $35.73 per ton in Q3 2013 to $2.96 per ton in Q3 2014. This was primarily because of a fall in realized prices from $108.88 per ton in Q3 2013 to $69.04 per ton in Q3 2014. ^[1]

Shipments for the North American Coal operations rose from 1.62 million tons in Q3 2013 to 1.86 million tons in Q3 2014, due to higher export sales and additional sales from the signing of a new supply contract. Sales margin for the segment fell from a loss of $1.12 per ton in Q3 2013 to a loss of $13.06 per ton in Q3 2014. This was primarily because of a fall in realized prices from $98.95 per ton in Q3 2013 to $75.71 per ton in Q3 2014. ^[1]

Outlook

In view of the deterioration in the iron ore pricing environment since its last earnings announcement, Cliffs has lowered the expected revenue per ton outlook for its Eastern Canadian Iron Ore and Asia-Pacific Iron Ore operations from $85-90 to $80-85 and $85-90 to $75-80, respectively. ^[1] The company maintained its guidance for its reduced capital expenditure spend of $275-325 million for 2014, which is in line with its announcement in May, when the company cut its capital expenditure expectations by $100 million from its previous guidance. ^[1]

The company management also made comments pertaining to its Bloom Lake mine in Canada. It was of the view that the ongoing Phase I operations are not economically feasible. In order to reduce the production cost and improve profitability, the company needs to undertake Phase II expansion of the mine. The capital requirements for Phase II expansion would be approximately $1.2 billion. ^[3] In order to undertake this expansion, Cliffs is looking for strategic equity investors who will  take up an addtional 30% stake in the mine, along with signing offtake agreements for iron ore produced from Bloom Lake. These investors are likely to be integrated steel producers, such as Cliffs’ equity partners in its U.S. Iron Ore operations. ^[3] If the company is unable to attract investors by the end of the year, it would  idle the mine, instead of operating the unprofitable Phase I operations. Given that the subdued iron ore pricing environment is expected to prevail in the near term, we feel that this is a good move. The company is looking to undertake significant capital commitments only into projects that would be profitable, and at the same time is looking to lower its risk by seeking strategic investors. It is a good step in the company’s efforts to improve the  competitiveness of its iron ore mining operations.

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1. Cliffs Natural Resources Q3 2014 Earnings Release, SEC [↩] [↩] [↩] [↩] [↩] [↩] [↩] [↩] [↩]
2. Cliffs Natural Resources Inc. Expects to Include Non-cash Asset Impairment Charges within Its Third Quarter Results, Cliffs Natural News Release [↩]
3. Cliffs Natural Resources Q3 2014 Earning Call Transcript, SEC [↩] [↩] [↩]
4. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg [↩]
5. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association [↩]
6. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb [↩]
7. Iron Ore Spot Prices, Y Charts [↩]
8. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg [↩]
9. Coking coal price crashes through $100, Mining.com [↩]
10. Metallurgical Coal at 6-Year Low as Chinese Demand Slows, Bloomberg [↩]