The Lordlings of Iron Ore: How Can We Profit From Their Folly – Part III

By | June 1, 2014

On Part I and Part II I reviewed the current demand and supply conditions in the iron ore market. We saw that the market is about to be oversupplied with iron ore over the next to year and that should take a toll on the miners financial performance going forward. On top of that, I showed that powerful stakeholders such as the Chinese government, have strong interest in low iron ore prices and are taking actions towards that end. Now, it is time to see what scenarios are baked into the valuations of the miners and a see if we can identify any opportunities to bet against them. Here is the usual Twitter version (137 characters): “Market participants are overly optimistic about iron ore miners’ future performance and this optimism is reflected in their share prices.”

Let’s roll..

The Street’s View

I went on Bloomberg to see what the “leading steers” have to say about the iron ore market. Their (JPM, Deutsche etc.) analysis carries a lot of weight in the market. Surprisingly, their forecasts do not vary too much — that could be attributed to anchoring bias or to the institutional imperative. Here is what one had to say about the prices that RIO is expected to realize over the next two years:

rio tinto db report prices

We can see prices of $125 and $116 for 2014 and 2015, respectively. These prices are “CIF”, which means that they exclude the shipping costs from Australia to the destination (~$10/ton). I think that by now it is very easy to see that these expectations will not materialize but this report is from this month so go figure.

JPM is not only optimistic, but also confused. Here is a link to one of their reports that is publicly available. Look at that:

JPM confused about the iron ore prices

The upper table in the picture above is taken from a JPM report on Fortescue, the high-cost-low-quality Australian iron ore miner. In order to justify their valuation they had no choice but be very optimistic and use $126 as the unit price and $113 for next year. The table below, also from JPM (written by another analyst) where he predicts a price of $118 and $110 for 2014 and 2015, respectively. Not sure how many people read the disclosures on these reports, but it says that BHP, Rio and Fortescue are all clients of JPM’s investment banking unit, that also helps to explain the optimism. No wonder why VALE is not mentioned in that report…

Also, in the upper picture JPM predicts a price of $114/t for FMG (upper picture below the red circle), let’s see how the prices that FMG gets behaved recently:

TSIPIO58 Index (China import Iro 2014-05-28 12-20-44

Good luck with getting this one right, JPM.

Another thing the analysts did not relate to is the volumes sold. What if both prices and volumes go down? This is not at all unlikely. One can think of a scenario in which Chinese demand is cut by 30% and the prices are falling. Then companies like VALE (high shipping costs) and Fortescue (low realized prices due to low quality ore) will sit on a lot of unsold inventory and may even see losses.

To sum it up, the Street expects iron ore prices and volumes to go up. I don’t. So there you go, there is a disagreement and there are different views. Now a few words about each company…

Rio

Rio Tinto has good quality ore and it gets most of it in Australia, which makes shipping to China cheap and easy compared with VALE. However, analysts expect it to post an EPS of ~$5.5 in 2014 and $6 in 2015. Based on my analysis this is near impossible even without a catastrophe in China. Even if it happens, Rio trades near X10 these values and these are peak-of-the-cycle earnings so even if I’m wrong, the damage by betting against Rio can’t be huge but it will most likely not meet these expectations and it’s current valuation is too high.

Fortescue

Fortescue is the ugly duck in the mining business: it has a lot of debt, low quality iron ore but its valuation is really cheap right now compared with last year’s earnings. However, should things in China slow down this company can easily go bankrupt and its equity value might go down to zero. Fortescue sells almost all of its iron ore to China and if Chinese demand slows down Fortescue will be the first one to lose business because of it’s high costs and low grade iron ore. However, if it survives the next few years, there can be a sharp improvement in its valuation, therefore if you don’t have a very strong conviction that a terrible bear case is highly probable, I would be cautious. Given the situation in the spot market for iron ore grade 58 It is very hard to see how can Fortescue earn the $1.05/share that the Street expects.

Vale

Vale has a distance problem and it puts it at a cost disadvantage versus those who mine in Australia. It costs about $24/t to ship iron from Brazil to China while it costs only about $10/t to send it from Australia. As such, in order to sell it’s ore, Vale will have to compromise on a very low selling prices and may also get hit hard. Analysts expect it to make $2/share this year but I think it’s nearly impossible (given current conditions in the iron ore market) and it’s earnings will suffer badly in the coming years.

Conclusion

The next two years will reveal who was right and who got it wrong. One of the most important aspects of learning and improving oneself is to get feedback so I prepared the following table that contains the stock prices of the miners on the date I wrote Part I and the target prices that analysts have set for them. While I don’t set a concrete number, my prediction is that we will see much lower prices for these shares 1-2 years down the road. I set myself a reminder to come back and check it, here is the table:

Screen Shot 2014-05-29 at 11.25.34 am

 

 

 

 

Disclosure: I hold a short position on RIO and VALE. Each investor should do his/her own due-dilligence.

4 thoughts on “The Lordlings of Iron Ore: How Can We Profit From Their Folly – Part III

  1. Tamritz

    Regarding FMG, maybe it plays the same role as Golan Telecom in the Israeli telecom sector. It cannot make a lot of money by itself but it still has big value since the competitors willl agree to pay much money to buy it and shut it down. In the case of FMG maybe the chinese steel industry will outbid them out of determination to keep Iron Ore cheap.

    Reply
  2. Ali Nassimi

    There is a an important piece missing from your research. And it is how much it cost’s each player to produce. Currently big players are increasing capacity and that would push the prices down. The marginal producers will go out of business while those with smallest marginal cost might prosper as lower price is compensated by higher volume. I know that Brazil has some of the highest Iron ore grades in the world, so Vales grade advantage might be much greater than its shipping disadvantage.

    There are many marginal producers outside China who will not be subsidized and even in CHina Governments desire for cleaner environment may cancel its wish to keep mining jobs. I would suggest shorting those with marginal cost of more than 80$/ton. Shorting those with small marginal cost is very risky.

    Reply
  3. Yaniv Uliel Post author

    Ali, thanks for your comment, here are a few thoughts:

    1. This post-series isn’t and does not pertain to be a comprehensive research and there are many aspects that I didn’t touch upon in this review of the iron ore market. What you mentioned is an important data point but I am not going to write about all the small details of each idea on this blog 🙂

    2. Costs change quite drastically over the years so it is very difficult to predict it going forward. VALE’s ore is high grade as you mentioned but VALE has a $14/mt headwind when it comes to shipping costs. That does not mean they are not important, it just means it is difficult to base a decision on something that changes so fast, unless you were alluding to a high-level distinction between what we may call “high cost” and “low cost”, which leads me to my next point.

    3. The companies that have high costs usually trade at very low valuations. True, these companies may go bankrupt if I’m right about the over supply situation, but if I’m wrong then some of those stocks of marginal producers can double or triple. It’s up to each investor’s flavor, margin of safety requirements and level of conviction to decide how aggressive he/she wants to be.

    4. For some companies, even if they will sell everything that they produce, it will be very difficult to achieve the kind of EPS that analysts seem to expect on some iron-ore spot price scenarios. Take RIO as an example, if iron ore price will be at $80-$70/mt even if it does sell all the quantity it produces, it will be impossible to meet the market’s expectations and the current valuation may prove to be frothy.

    5. If demand from China will slowdown and the economy with it, I doubt if the Chinese government will let mines go out of business and add to unemployment and economic stress that the country might be in.

    Reply
    1. Ali

      Yaniv, thank you for sharing your thoughts, I enjoyed reading them.

      I do not have access to analyst research but I guess they are using their assumed price to suggest some target price. I am an Iron Ore bear too, so if we are right their target price won’t be achieved. But whether there is going to be a large drop in share price would depend on if their revenue is hit hard. Which require the margin*volume to drop.

      In 2012 when prices dropped below 100$/t there was a rapid rebound which some bulls suggest was due to marginal producers exiting the market. I am not sure of the reason as it might have been consumption side effect but is a point worth considering.

      Reply

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