Lower Iron Ore Prices Weigh on Vale’s Q2 Results

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Vale (NYSE:VALE), the world’s largest iron ore mining company, announced its second quarter results and conducted a conference call with analysts on July 31.  As expected, lower iron ore prices in the second quarter as compared to the corresponding period last year negatively impacted the company’s results, with higher volumes offsetting some of the negative impact of lower prices. Net operating revenues for the quarter stood at  $9.9 billion, around 7% lower than the figure for the corresponding period last year, which stood at $10.66 billion. [1] Vale reports an underlying earnings figure, which excludes the effects of items such as impairments, foreign exchange and currency swap gains on net income, and is an indicator of the company’s operating performance. Underlying earnings fell nearly 15%, from $2.31 billion in Q2 2013 to $1.96 billion in Q2 2014. ((Vale’s Q2 2014 Earnings Release, SEC))

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The average realized price for Vale’s iron ore fines stood at $84.60 per ton in Q2 2014, nearly 18% lower than the average price for Q2 2013, which stood at $102.66 per ton. [1] The sale of iron ore and iron ore pellets collectively accounted for around 73% of Vale’s net operating revenues in 2013. [2] The decline in iron ore prices was primarily responsible for Vale’s poor quarterly results.

Iron ore is an important raw material for the steel industry. Thus, demand for iron ore by the steel industry plays a major role in determining its 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] Flagging demand for iron ore from China in the wake of an economic slowdown earlier on in the year, 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 slowed to multi-year lows in the first two months of the year. [4] 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. [5] 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. Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. [6] Weak demand for steel has indirectly resulted in weak demand for iron ore.

On the supply side, expansion in production by iron ore 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. [7]

Production Volumes

With iron ore prices expected to remain subdued in the near term, the company has adopted a high production volumes strategy. Vale expects to benefit from economies of scale, capitalizing on its low-cost iron ore deposits. In keeping with this strategy, the company’s iron ore production in Q2 2014 rose to 79.4 million tons, which is Vale’s highest ever second quarter production figure. Iron ore production in the second quarter was 12.6% higher than in the corresponding period last year. The increase in production was due to the ramp-ups of Plant 2 in Carajás and the Conceição Itabiritos plant. [8] In keeping with its high volumes strategy, various projects are expected to result in a growth in Vale’s iron ore production from 321 millions tons in 2014 to 453 million tons in 2018. [9]

Nickel production stood at 61,700 tons in Q2 2014, 5.2% lower than the corresponding period a year ago. This fall in production was mainly due to suspension of operations at the Sudbury mining complex, as a result of an accident and scheduled maintenance activity. Copper production stood at 81,000 tons, down 11.3% from the corresponding period a year ago, primarily due to scheduled maintenance activity at the Sudbury mining complex. Coal production stood at 2.2 million tons in Q2 2014, up 23.8% sequentially, due to higher output from the Carborough Downs and Moatize operations. ((Vale’s Q2 2014 Production Report, Vale Website))

Costs

In view of the weak iron ore pricing environment, Vale has adopted a strategy of cost reduction, disciplined capital allocation and divestment of non-core assets, in order to remain competitive. In the first half of the year, the company realized $249 million in savings in costs and expenses as compared to the corresponding period last year. [1] The main components of this decline in costs and expenses were selling, general and administrative expenses, which decreased by over 25%, and pre-operating and stoppage expenses, which decreased by close to 4%. [10] As a result of the company’s emphasis on cost reduction, its iron ore cash cost per ton fell from $23.9 in Q2 2013 to $22.1 in Q2 2014. [1]

Vale’s capital expenditure for the first half of the year stood at $5.1 billion, $2.1 billion lower than the $7.2 billion in capital expenditure incurred in the corresponding period last year. [10] This reflects the lower capital expenditure budgeted for 2014 as part of its disciplined approach to capital allocation.

The company sold-off its stake in FIP Vale Florestar in the second quarter, a fund for investment in reforestation, for around $92 million. ((Vale Sells Stake In Vale Florestar, Vale Press Release)) This is a part of Vale’s efforts to sell off its non-core assets in order to allocate capital in projects with better returns. With the subdued iron ore pricing environment set to continue in the near term, cost reduction, disciplined capital allocation and divestment of non-core assets may continue to be the theme for Vale for some time to come.

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Notes:
  1. Vale’s Q2 2014 Earnings Release, SEC [] [] [] []
  2. Vale’s 2013 20-F, SEC []
  3. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg []
  4. China Premier Warns On Economic Slowdown As Data Fans Stimulus Talk, Reuters []
  5. The Latest Iron Ore Price Slump: Causes and Effects, Forbes []
  6. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association []
  7. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb []
  8. Vale’s Q2 2014 Production Report, Vale Website []
  9. Vale Day 2013 Presentation, Vale Website []
  10. Vale’s Q2 2014 Earnings Conference Call Transcript, Seeking Alpha [] []