How Cliffs Would Benefit From A Recovery In Iron Ore Prices

Iron ore prices have declined sharply over the course of the last year or so. Benchmark 62% Fe iron ore fines prices stood at $58 per dry metric ton (dmt) at the end of Q1 2015, around 45% lower on a year-over-year basis ^[1]. Iron ore prices have declined due to a combination of weakness in demand and rising global iron ore production, resulting in an oversupply situation. This has negatively impacted the prospects of iron ore mining companies such as Cliffs Natural Resources (NYSE:CLF).

(Iron Ore Prices, Source: Y Charts)

We expect iron ore prices to remain subdued in the near term, with prices recovering gradually only after the global supply glut dissipates. However, there is a possibility of a sharper V-shaped recovery in prices, if sufficient high-cost iron ore supply goes out of the market. The current level of iron ore prices is too low to sustain significant quantities of high-cost iron ore production, particularly from domestic Chinese iron ore producers. Production cutbacks in response to low prices are likely to result in a more favorable demand-supply equation, which would boost iron ore prices. Such a scenario would significantly boost the prospects of Cliffs Natural Resources. In this article, we will explore the impact of a V-shaped recovery in iron ore prices on the company.

Impact of V-shaped Recovery in Iron Ore Prices on Cliffs Natural Resources

Iron ore is primarily used as a raw material in the production of steel. Thus, the demand for iron ore by the steel industry plays a major role in determining its 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 both steel and iron ore in the world. Though China does produce iron ore domestically, it imports a significant proportion of its iron ore requirements, accounting for over 60% of the seaborne iron ore trade. ^[2] With Chinese economic growth slowing, the demand for steel, which is largely correlated with macroeconomic growth, is also slowing. As per the latest IMF estimates, Chinese GDP growth is expected to slow to 6.8% and 6.3% in 2015 and 2016, respectively, from 7.4% in 2014. ^[3] As per estimates by the World Steel Association, Chinese steel demand growth is expected to decline by 0.5% in 2015, following on from a 3.3% decline in 2014. ^[4] Weak demand for steel has indirectly resulted in weak demand for iron ore. Thus, demand for iron ore in the near term is unlikely to grow at rates seen over the last couple of years.

The supply side is characterized by an expansion in production by major iron ore mining companies. Companies such as Vale, Rio Tinto, and BHP Billiton are rapidly ramping up their iron ore production, despite weakness in demand. These companies have low-cost iron ore deposits and are able to operate profitably even at current price levels. ^[5] These companies are betting on the long-term strength of iron ore demand from China, and the curtailment of high-cost iron ore production capacity, to bring the demand-supply equation back into balance. As per projections by major Wall Street banks, the worldwide surplus of seaborne iron ore supply is expected to rise to 300 million tons in 2017, from an expected surplus of 175 million tons in 2015, and a surplus of 72 million tons and 14 million tons in 2014 and 2013, respectively. ^{[6] [7]}

The world’s lowest cost iron ore miners such as Rio Tinto and Vale break even at price levels below $50 per ton. ^[8] Thus, these companies can continue to produce profitably even if prices fall further. However, the current levels of iron ore prices are insufficient for high-cost iron ore producers, particularly domestic Chinese iron ore miners. China is the world’s largest producer of iron ore. ^[9] Around 80% of Chinese domestic iron ore producers break even at prices levels of $80-90 per ton. ^[8] If prices remain at current levels for a long time, a significant proportion of these producers may be forced to cut back on production. Such a scenario would result in a more favorable global supply-demand equation which would boost iron ore prices.

If we assume that this scenario materializes and iron ore prices recover sharply, it would significantly boost realized prices and margins for Cliffs’ iron ore mining operations, as compared to the assumptions currently factored into our stock price model for the company. In our base case scenario, realized prices for the North American Iron Ore division rise to $92 per ton by 2021, as shown in the interactive graph below:

In our alternative scenario, realized prices for the division rise to $100 per ton by 2021 . In addition, the recovery in iron ore prices would also impact realized prices and margins for the Asia Pacific Iron Ore division. In the alternative scenario, we have assumed that the company’s production and capital expenditure plans remain unchanged. However, whereas absolute capital expenditure will remain unchanged in the V-shaped recovery scenario, capital expenditure expressed as a percentage of EBITDA (as forecast in our model) will decline due to higher EBITDA generated by the company in the V-shaped recovery scenario. If we factor in higher realized prices and margins and the corresponding capital expenditure forecasts for Cliffs’ iron ore mining operations, our price estimate for the company increases by around 114% from $6.35 to $13.59. Thus, in the event of a sharp recovery in iron ore prices, an upward adjustment in valuation could potentially follow for Cliffs Natural Resources.

See our complete analysis for Cliffs Natural Resources in the scenario of a V-shaped recovery in iron ore prices

View Interactive Institutional Research (Powered by Trefis):
Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap
More Trefis Research

1. Iron Ore Prices, Y Charts [↩]
2. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg [↩]
3. World Economic Outlook January 2015, IMF [↩]
4. Short Range Outlook 2015-2016, World Steel Association [↩]
5. BHP, Rio Gamble with Stacked Iron Ore Deck, Mineweb [↩]
6. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg [↩]
7. Iron Ore Caps 2014 Loss as Morgan Stanley Says Worst Over, Bloomberg [↩]
8. Iron Ore Slump No Bar to Supply as China Mines Shut: Commodities, Bloomberg [↩] [↩]
9. Iron Ore Production, U.S. Geological Survey 2014 [↩]