In an expected event, Vale (NYSE:VALE) is in negotiations with ArcelorMittal (NYSE:MT) and China Steel Corp. over quarterly iron ore contract pricing and the method of determining prices.  Iron ore miners moved to a quarterly pricing mechanism from an annual contract pricing method a few years back in order to take advantage of rising prices. However, with prices falling steel manufacturers are pushing for a better pricing mechanism, whereby the prevailing market price for the ore is better reflected in the contract price. This shift would likely benefit steel makers but hurt the miners. Vale is the world’s largest iron-ore mining company and receives 18 percent of its value from the nickel business. It competes internationally with other mining giants like Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP).
We have revised our price estimate for Vale from $34 to $31, which is still about 40% ahead of the market price.
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Revising our iron ore price estimate
The decline in the global demand for steel has led to a decline in iron ore prices as well. Over the past few months, steel manufacturers are facing huge losses due to high raw material costs (iron ore and coal), forcing them to close down some of their mills.
Iron ore producers like Vale still enjoy EBITDA margins above 50% on their operations. Therefore it’s now their turn to absorb some of the losses related to declines in demand. Accordingly, we have revised our estimate for the average realized price of iron ore to 10% growth compared to our earlier estimate of 30%. In 2013 we expect a decline in iron ore prices as production in China rises, creating a probable oversupply situation. We expect Vale’s average realized price of iron ore to settle around $105 per ton by the end of our forecast period. Due to global economic uncertainty, we have also revised our estimates for copper, aluminium and nickel.
Steel manufacturers demand better iron ore contract pricing
Iron ore contracts are priced based upon the average market price of iron ore in the month preceding the date of the contract. Now, with a downward trend in prices, negotiating a contract price based upon an older price hurts steel manufacturers as they have to pay a price that can be substantially higher than the actual market price. Accordingly, steel manufacturers are now demanding that the price at which a contract is finalized be taken from the commodity’s average market price in the month in which the contract starts (as opposed to the preceding month). Such a pricing mechanisim will be beneficial for steel manufacturers and overall market dynamics in the long run as it more closely reflects the prevailing market prices.
We could potentially see a 20 percent near-term reduction in Vale’s iron ore contract prices should the newer mechanism be implemented. We may also see shorter contract durations in the future if the price of iron ore remains as volatile as it has been in the past few years.Notes: