Rio Tinto vs Vale: The Importance Of Geographical Proximity To China

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Vale (NYSE:VALE) and Rio Tinto (NYSE:RIO) are the world’s top two producers of iron ore in terms of production volumes. Both companies also rank among the world’s lowest cost producers of the commodity. Given the prevailing subdued pricing environment for iron ore, both companies have been looking to further reduce their production costs in order to operate competitively. However, there is one distinct competitive advantage that Rio enjoys over Vale — geographical proximity of its mines to China, the world’s largest iron ore consumer, and the biggest market for both Vale and Rio Tinto. In this article, we will examine how geographical proximity to China gives Rio Tinto a competitive advantage over Vale, and what Vale is doing to mitigate the extent of the disadvantage.

The Importance of China in the Iron Ore Market

Iron ore is primarily used as a raw material in the production of steel. Thus, demand for iron ore by the steel industry plays a major role in determining its prices. Benchmark international iron ore prices are largely determined by Chinese demand, since China is the largest consumer of iron ore in the world. Apart from its domestic iron ore production, China also accounts for more than 60% of the seaborne iron ore trade. [1]

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China is the largest market for the iron ore sales of both Rio Tinto and Vale. Vale’s iron ore sales to China account for around 46% of the company’s overall revenues from iron ore sales. [2] Including Japan and other smaller Asian markets, Asia as a whole accounts for around 65% of Vale’s overall revenues from iron ore sales. [2] Similarly, China and Asia account for 38% and 69% respectively, of Rio Tinto’s overall revenues, the bulk of which are derived from iron ore sales. [3] Thus, China is the most important market for iron ore, and the fortunes of both companies are, to a large extent, tied to Chinese demand for the commodity.

Iron Ore Prices

China is the world’s largest producer of steel and the largest consumer of iron ore, which is an important steelmaking raw material. However, slowing economic growth in the country has negatively impacted growth in the Chinese demand for steel. Chinese steel demand growth is expected to decline by 0.5% in 2015, following on from a similar decline in 2014. [4] Weak demand for steel has translated into weak demand for iron ore.

On the supply side, an expansion in production by major iron ore mining companies such as Vale, Rio Tinto, and BHP Billiton has created an oversupply situation. [5] 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] Prices have fallen sharply over the course of the last year as shown by the following graph.  Iron ore prices stood at $58 per dry metric ton (dmt) at the end of March, around 45% lower as compared to prices a year ago. [8]

(Source: Y Charts)

A combination of weak demand and oversupply is likely to result in weak iron ore prices in the near term, which makes reducing costs vital in order to operate competitively in the prevailing market conditions.

Transportation Costs and Rio Tinto’s Advantage

The majority of Rio’s iron ore mining operations are located in the Pilbara region of Western Australia, whereas Vale’s iron ore mining operations are concentrated in Brazil. Western Australia is geographically much closer to China as compared to Brazil. To put this into context, iron ore shipments from Brazil take around six weeks to reach China, as compared to only nine days for shipments from the Pilbara region of Western Australia. [9]

Vale and Rio Tinto are two of the world’s lowest cost iron ore producers, with cash costs of production (excluding depreciation) for both companies standing close to $20 per ton. [10] However, transportation costs for Vale’s iron ore shipments to China are around $22 per ton. Australian producers such as Rio Tinto enjoy a $10 per ton advantage in terms of transportation costs to China. [11] Thus, given that both companies have similar production costs, lower transportation costs for Rio Tinto become a source of competitive advantage for Rio Tinto, particularly given the prevailing environment of low iron ore prices.

Vale’s Strategy to Reduce Transportation Costs

Vale opted for economies of scale in order to lower its transportation costs by augmenting its transportation fleet with the Valemax ships over the last few years. The Valemax ships are the world’s largest dry bulk carriers, which have a capacity of 400,000 dead weight tons (dwt). These vessels have 2.3 times the capacity of Vale’s Capesize ships, that ordinarily ply the route between Brazil and China. [12]

However, until recently, the Valemax ships were not allowed to dock at Chinese ports due to opposition from the Chinese shipping industry. Chinese shipping companies argued that allowing Valemax ships to dock at Chinese ports would exacerbate the overcapacity in the shipping industry. Overcapacity in the global shipping industry has lowered freight rates and forced many Chinese companies into the red. [13] As a result, in order to transport iron ore to China, the Valemax ships used to deliver iron ore to Vale’s regional distribution hubs in the Philippines and Malaysia, from where cargo was transferred to smaller ships, which were permitted to dock at Chinese ports. [13]

As a result of protracted negotiations between Vale and Chinese authorities, Chinese shipping regulations were changed earlier this year to allow Valemax vessels to dock at Chinese ports. [14] As a result of this change in regulation, Vale will save about $7 per ton over current costs. [11] Thus, the go-ahead for Valemax ships to dock at Chinese ports is a major breakthrough which will significantly reduce Vale’s $10 per ton transportation cost disadvantage vis-a-vis its Australian rivals such as Rio Tinto.

Given the oversupplied iron ore markets that iron ore producers are dealing with, cost reduction will continue to be the major strategic thrust for these companies in the near term. Thus, the lowering of its transportation costs provides some much needed respite for Vale, and diminishes its relative competitive disadvantage.

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Notes:
  1. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg []
  2. Vale’s 2014 20-F, SEC [] []
  3. Rio Tinto Chartbook, Rio Tinto Website []
  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 Spot Prices, Y Charts []
  9. Are Rio Tinto Limited, Vale SA and BHP Billiton Limited Destined For the Scrap Heap, Motley Fool []
  10. Vale Day Presentation, Vale Website []
  11. China wants shipping partnership with Brazil’s Vale, Yahoo Finance [] []
  12. Shipping division, Vale website []
  13. China permits giant Valemax to dock, Financial Times [] []
  14. China lifts three-year ban on Valemax cargo ships, South China Morning Post []