Vale Continues Portfolio Optimization Efforts In Subdued Iron Ore Pricing Environment

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Vale (NYSE:VALE) recently announced the sale of its entire stake in Vale Florestar Fundo de Investimento em Participações (FIP Vale Florestar) to Suzano Papel e Celulose (Suzano), for around $92 million. FIP Vale Florestar is a fund for investment in reforestation, which operates in the state of Pará, Brazil. Suzano is engaged in the production of eucalyptus pulp. [1]

The sale of Vale’s stake in FIP Vale Florestar closely follows its announcement to idle its Integra Mine Complex in Australia, which produces metallurgical coal. Vale believes that operations are currently not economically feasible under the prevailing weak coal pricing environment. Technically, the Integra Mine Complex has been put under ‘care and maintenance’, a status that will allow the mine to be reopened quickly if market conditions improve. [2] These events are a part of Vale’s strategy to optimize its portfolio as well as adopt discipline in capital allocation.

Following such a strategy is imperative, given the subdued iron ore pricing environment. The sale of iron ore and iron ore pellets accounted for around 73% of Vale’s net operating revenues in 2013. ((Vale’s 2013 20-F, SEC)) Thus, iron ore prices have a major impact on the prospects of Vale, the world’s largest iron ore producer.

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Iron Ore And Coal Prices

Vale’s iron ore and iron ore pellets are sold to the global steel industry. Demand for iron ore by the steel industry plays a major role in determining 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. China also accounted for nearly half of Vale’s iron ore and iron ore pellet shipments in 2013. 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. [3] A Chinese government crackdown on polluting steel plants has forced many of them to shut down. In addition, the tightening of credit by Chinese banks to steel plants that are not performing well will affect their ability to purchase iron ore, and hence, the overall demand for it. This has resulted in an inventory build-up at Chinese ports which will further curtail imports. Further, 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 iron ore in the long run. [4]

On the supply side, iron ore majors such as Rio Tinto and BHP Billiton have expanded production of the ore. These companies are banking on higher volumes to compensate for lower prices and drive profits given their low costs of production of iron ore. These companies are betting on continued strength in iron ore demand over the long term. The main drivers of such long term demand are increasing levels of urbanization and industrialization in developing and emerging economies, particularly China and India. However, given the weak demand scenario at least in the near term, expanded production by iron ore majors has resulted in an oversupply situation, which is expected to keep prices subdued in the near term. [5]

Vale’s average realized iron ore price has declined from $ 143.46 per ton in 2011 to $107.43 per ton in 2013. [6] It further declined to $90.52 per ton in Q1, 2014. [7]

China is also the largest consumer of metallurgical coal in the world. There has been falling demand for the commodity by the Chinese steelmaking industry along with lower demand from other major consumers such as Japan and the EU. Falling demand coupled with an oversupply situation due to expansion in production by major mining companies has resulted in plummeting coal prices. [8] This has negatively impacted Vale’s coal business, particularly the Integra Mining Complex, which produces metallurgical coal.

Vale’s Response

In view of the weak iron ore and coal pricing environment, Vale has adopted a strategy of cost reduction, disciplined capital allocation and divestment of non-core assets in order to remain competitive. Vale has embarked upon a mission to optimize its portfolio, divesting non-core assets in order to free up capital and invest it in projects that will give better returns. The company sold non-core assets and investments worth $6 billion in 2013. [9] The sale of its stake in FIP Vale Florestar is a continuation of Vale’s efforts to divest non-core assets.

In addition, the company has also significantly reduced its capital expenditure. Going forward, it is focusing on a smaller project pipeline that would generate greater value for shareholders. Vale’s capital expenditure reduced from $16.2 billion in 2012 to $14.2 billion in 2013. The company’s capital expenditure budget for 2014 is even lower at $13.8 billion. [6]  The decision to idle its Integra Coal Mine is consistent with its strategy to allocate capital to projects that will generate better returns.

As a part of its efforts to enhance efficiency and cut costs, Vale generated savings of $2.8 billion in 2013. [9] The company continued to achieve results in its cost reduction efforts with savings of $218 million in Q1 2014, as compared to the corresponding period last year. [10] In addition to cutting costs, the company plans to expand production to lower unit costs by diluting total costs over larger production volumes. Various planned iron ore projects will ramp up Vale’s iron ore production capacity from 306 million tons per annum in 2013 to 450 million tons per annum in 2018. [11]

Vale’s efforts to reduce costs and exert discipline in capital allocation were recognized by Moody’s, which changed its rating outlook from neutral to positive. [7] A ratings upgrade should lower the company’s costs of borrowing.

The Road Ahead

The weak pricing environment for both iron ore and coal is set to continue in the near term, as an oversupply situation will persist for some time for both the commodities. Under such conditions, focus on core assets and cutting costs will continue to be the mantra for Vale. There may be more divestments of non-core assets in the near term.

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Notes:
  1. Vale Sells Stake In Vale Florestar, Vale Press Release []
  2. Vale Comments On Integra Coal Mine, Vale Press Release []
  3. China Premier Warns On Economic Slowdown As Data Fans Stimulus Talk, Reuters []
  4. The Latest Iron Ore Price Slump: Causes and Effects, Forbes []
  5. BHP, Rio Gamble With A Stacked Iron Ore Deck, Mineweb []
  6. Vale’s 2013 20-F, SEC [] []
  7. Vale’s Q1 2014 6-K, SEC [] []
  8. Coking coal price crashes through $100, Mining.com []
  9. Vale’s Q4 2013 Earnings Conference Call Transcript, Seeking Alpha [] []
  10. Vale’s Q1 2014 Earnings Conference Call Transcript, Seeking Alpha []
  11. Vale Day 2013 Presentation, Vale Website []