Lower Iron Ore Prices And Shipments Weigh On Vale’s Q3 Results

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Vale (NYSE:VALE), the world’s largest iron ore mining company, announced its third quarter results and conducted a conference call with analysts on October 30. As expected, lower iron ore prices in the third quarter as compared to the corresponding period last year negatively impacted the company’s results. Further, despite record  iron ore production levels in Q3 2014, which stood at 85.7 million tons, around 3.1% higher than in Q3 2013, iron ore sales volumes fell 9.3% year-over-year to 66.6 million tons. [1] This was mainly as a result of the accumulation of 9.3 million tons of inventories along the supply chain in the quarter, partially as a result of the interruption of the Carajas Railroad in September. A portion of the inventory was built up intentionally to be sold at more favorable terms in Q4. [2] Net operating revenues for the quarter stood at  $9.06 billion, around 26.5% lower than the figure for the corresponding period last year of $12.33 billion. [2] 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 81.7%, from $3.64 billion in Q3 2013 to $666 million in Q2 2014. [2]

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The average realized price for Vale’s iron ore fines stood at $68.02 per ton in Q3 2014, nearly 38% lower than the average realized price for Q3 2013, which stood at $109.93 per ton. ((Vale’s Q3 2014 Earnings Release, SEC)) The sale of iron ore and iron ore pellets collectively accounted for around 73% of Vale’s net operating revenues in 2013. [3] 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. [4] Weak demand for steel in China has translated into weak demand for iron ore. Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. [5] A slowdown in economic growth has tempered the demand for steel. China’s GDP growth is expected to slow to 7.3% and 7.1% in 2014 and 2015 respectively, from 7.7% in 2013. [6] Further, 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 mills that are not performing well, will negatively impact these mills’ prospects. [7] 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. The weak Chinese economic prospects are captured by the Manufacturing Purchasing Managers’ Index (PMI). The Manufacturing PMI measures business conditions in the manufacturing sector of the concerned economy. When the PMI is above 50, it indicates growth in business activity, whereas a value below 50 indicates a contraction. Chinese Manufacturing PMI, reported by China’s National Bureau of Statistics, stood at 51.1 for September, and has ranged between 50.2 and 51.7 for the whole year. [8] With weak Chinese manufacturing growth, demand for steel is expected to remain subdued in China.

On the supply side for iron ore, expansion in production by majors such as Rio Tinto and BHP Billiton despite weak Chinese demand, has created an oversupply situation. [9] 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. [10] Due to the persisting weak demand and oversupply situation, iron ore prices will remain under pressure in the near term.

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 Q3 2014 rose to 85.7 million tons, which is Vale’s highest ever quarterly production figure. Iron ore production in the third quarter was 7.9% higher than in Q2 2014 and 3.1% higher than in Q3 2013. The increase in production was due to the ramp-ups of Plant 2 in Carajás and the Conceição Itabiritos plant. ((Vale’s Q3 2014 Production Report, Vale Website)) 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. [11]

Nickel production stood at 72,100 tons in Q3 2014, 16.4% higher than in the corresponding period a year ago. This was primarily due to the ramp-ups of production at the Sudbury mining complex in Canada and the Onca Puma mining complex in Brazil, offset by lower production from the company’s operations in Indonesia and New Caledonia. [12] Copper production stood at 104,800 tons, up 10.8% from the corresponding period a year ago, primarily due to ramp-ups of production at the Sudbury and Salobo mining complexes. [12] Coal production stood at 2.3 million tons in Q3 2014, up 5.9% sequentially, due to higher output from the Carborough Downs, Moatize and Isaac Plains operations. ((Vale’s Q3 2014 Production Report, Vale Website))

Costs

In view of the weak iron ore pricing environment, Vale has adopted a strategy of cost reduction and disciplined capital allocation, in order to remain competitive. In the first nine months of the year, the company realized $520 million in savings in costs and expenses as compared to the corresponding period last year. ((Vale’s Q3 2014 Earnings Release, SEC)) The main components of this decline in costs and expenses were selling, general and administrative expenses, which decreased by around 23%, and pre-operating and stoppage expenses, which decreased by around 46%. [2]

Vale’s capital expenditure for the first nine months of the year stood at $8.23 billion, $2.16 billion lower than the capital expenditure incurred in the corresponding period last year. ((Vale’s Q3 2014 Earnings Release, SEC)) This reflects the lower capital expenditure budgeted for 2014 as part of its disciplined approach to capital allocation. The decision to idle the Isaac Plains coal mine, announced in September, is consistent with its strategy to allocate capital to projects that will generate better returns. [13]

With the subdued iron ore pricing environment set to continue in the near term, Vale will persist with its strategy of cost reduction and  disciplined capital allocation.

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Notes:
  1. Vale’s Q3 2014 Earnings Presentation, Vale Website []
  2. Vale’s Q3 2014 Earnings Release, SEC [] [] [] []
  3. Vale’s 2013 20-F, 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. Goldman Sachs cuts China growth forecast sharply, Market Watch []
  7. The Latest Iron Ore Price Slump: Causes and Effects, Forbes []
  8. China Manufacturing PMI, Trading Economics []
  9. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb []
  10. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg []
  11. Vale Day 2013 Presentation, Vale Website []
  12. Vale’s Q3 2014 Production Report, Vale Website [] []
  13. Vale comments on Isaac Plains mine, Vale News Release []