Could Vale Shatter The Iron Ore Market?

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Greg Peel

Brazilian miner Vale (formerly CVRD) is the world’s biggest producer of iron ore, a proportion of which is the world’s highest quality iron ore. Having already, earlier in the year, negotiated a 65-71% increase in contract price (depending on grade) with Chinese steel mills for the 2008-09 year, it has been revealed Vale has suddenly asked for a mid-contract price increase of up to another 20%.

In the first half of 2008, when annual contract prices began to be settled amongst the world’s iron ore producers and steel mills, analysts where already suggesting that despite increases of up to 85% this year, next year (2009-10) would see yet further increases in the order of another 20%. If ever there were a bullish story in a bearish market, it was bulk commodities – iron ore and coal.

Prima facie therefore, one might suggest those analyst predictions may have already come true six months early, thus providing vindication. Before we’ve even reached the next negotiation period, iron ore prices are going up. This has to be bullish for the share prices of the world’s iron ore producers, surely.

Or perhaps not.

To appreciate why not, a little history is required. And let’s begin with a map of the world.

Just about all of Australia’s iron ore leaves by boat from Port Hedland on Australia’s west coast. Brazil’s iron ore obviously leaves from its east, and only, coast. To reach China, bulk carriers leaving Port Hedland simply turn right and steam north in what is a relatively quick trip. On the other hand, carriers from Brazil are faced with a journey of Magellanic proportions, whichever direction they head.

Clearly it thus costs less to ship iron ore to China from Australia, which should give Australia the opportunity to receive an effectively higher gross price for its iron ore if the landed price paid in China is the same as that for Brazilian ore. However, somewhere back in the glum days of low commodity prices, when China was just “starting out”, Australian iron ore producers agreed to make a concession. While one might expect that concession to mean Australia would accept a lower price for its iron ore to net out its distance advantage, for some reason BHP Billiton ((BHP)) and Rio Tinto ((RIO)) agreed to a margin reduction that meant Australian ore was sold at even cheaper prices than the differential suggested. They just wanted to sell iron ore to China. China was holding all the cards.

It is the nature of the Chinese culture that when you do a deal, that deal is set for life (at least for as long as it is to the benefit of the Chinese). But as the decade has progressed, the Chinese economic growth story has astounded all and sundry, including iron ore producers. The mad scramble has been on to expand iron ore production across the globe. As demand growth for Chinese steel production has shot well ahead of available new supply, the price of iron ore has skyrocketed. In early 2008 the Chinese were paying up to 200% more than just the year before to buy lower grade Indian ore at spot to make up the shortfall from the annually contracted shipments from Australia and Brazil. At the same time, the oil price was racing to a record high.

The latter factor only served to blow out that freight differential between Australia and Brazil even further. Then there was a small matter of not enough ships, which pushed freight costs even higher still. BHP had already had enough of the price disparity a few years earlier, but each time it told the Chinese “this time it will be different” the Chinese responded with a smile, “no it won’t”. BHP, by itself, did not have enough clout to overcome the dominant Brazilians, who had become very good mates with China (or as an Aussie might say, very good Chinas). Nor, by itself, did Rio. So each year the two Big Aussies accepted the fate that Vale would set the first price for the year, and the Aussies would fall meekly into line. At a price that was even cheaper than the freight differential implied.

Two years ago, however, BHP and Rio colluded. They would go to the Chinese, after Vale had set a price, and politely tell them what they could do with their freight differential. The Chinese were incensed. A deal is a deal. But this time it was the iron ore producers who were in the box seat. Together, BHP and Rio produce more ore than Vale.

It might have worked, if Rio hadn’t have reneged on BHP. Once again the Australian producers accepted a lesser price. Last year saw only a small rise in the annual contracted price so there was not much leverage to be used. But in 2008…

In 2008, as noted, China was more desperate for iron ore than ever before (did they need the steel for the Bird’s Nest?) and hence were paying 200% more in the spot market. Rio had a new CEO who this time was ready to stand shoulder to shoulder with his compatriot. The Aussies took on the Chinese, and won. Vale made the first move, as usual, and negotiated a price rise of 65-71%. Australia argued for a concession on the freight differential, and as a result scored a price rise of 79-85%.

This time it was the Brazilians’ turn to be incensed.

So suddenly, out of the blue, Vale has announced to the Chinese that its iron ore would not be hitting the oceans until the steel producers agree to an additional 20% price hike. This has surprised many who assumed an annual contract is an annual contract, but since the Chinese have now screwed their mates then they ain’t mates no more. The extra 20% (Vale argues it’s only 13% but let’s not get bogged down) is simply the price advantage lost when the Aussie freight deal was broken.

It also happens to nicely fit in with analyst predictions earlier this year that 2009-10 would see another 20% price rise anyway. On that basis, one could say the Brazilians have just gone early. From this point of view you’d have to believe Vale’s actions are thus bullish for all iron ore producers – next year will see higher prices again.

But there’s one small problem.

In the first half of 2008, when this year’s iron ore contract prices were being set, the global commodities bubble was accelerating at a breakneck pace. In the second half of 2008, that bubble has burst. The oil price is down 27%. The copper price is down 20%. The gold price is down 22%. Even the spot coal price is trading down 20%. Where has this left iron ore?

The spot price for iron ore has also begun to drop. This reflects the fact Chinese steel production has now gone into a decline. While commodities prices may have reached levels early in 2008 which triggered “demand destruction”, such destruction came about at the same time the inevitable consequence of the global credit crunch began to become apparent. The global economy is now heading into recession. Japan, Europe and UK have all posted second quarter economic contractions. The US is a contraction waiting to happen.

The Chinese government has now realised it can stop trying to reel in the country’s runaway economic growth from 12% to a more manageable 8-9% because the slowing global economy will achieve that anyway. A growth rate of 8-9% would be a boom in anyone else’s language, but in China’s case it’s as good as a recession. The Chinese export industry is rapidly contracting. It is only the domestic economy now driving the ship.

Stockpiles of iron ore have begun to build up at Chinese ports. The only reason the spot market is still operating is because the smaller Chinese mills, way down the list from the mighty Baosteels and Sinosteels, do not have the clout to negotiate annual contracts with the big suppliers.

At the same time, global iron ore production is finally beginning to ramp up to new levels of supply. Fortescue Metals ((FMG)) has delivered its first shipment to China with the promise of many more to come. Fortescue will become a globally significant producer once fully operational, yet one year ago it effectively didn’t exist. BHP, Rio and Vale are all bringing new production into line. New rail lines are being built to speed up the delivery process. Ports are being expanded. Vale has commissioned the construction of a whole armada of new bulk carriers.

It is now possible that in 2009 global iron ore supply could exceed demand.

And this is the environment in which Vale wants to break contract and go for another 20% price rise. Is it mad?

Or is Vale just being foolishly petulant, throwing a tanty in the sandpit because the other kids got more? Mind you, Vale does not have the monopoly on smugly trying to screw over the Chinese. In the lead up to the 2008-09 price negotiations, Rio managed to infuriate the Chinese by withholding 10% of its contracted ore and selling it at spot. Rio’s contract allowed a margin of error of 90% delivery, and so Rio exploited it.

As we speak, Rio has declared force majeure on its contract deliveries given an accident at its Cape Lambert rail operations, which may shut down transport for a month. Fair enough, except that as one bemused analyst rightly asked, doesn’t Rio have plenty of other sources of supply? Why does it have to declare force majeure on all deliveries? Perhaps because Rio wants to force the price up. Perhaps because despite the concession afforded at this year’s price negotiations, BHP and Rio only got an 85% raise when 100%-plus was what they really wanted. That difference has a lot to do with why analysts were looking for another 20% rise in 2009-10.

But aside from such price-push shenanigans, Vale has a more pressing reason to want to negotiate back its longstanding freight advantage. The reason is that BHP plus Rio equals more than Vale. If BHP successfully takes over Rio, the merged entity will become the new world leading producer of iron ore, relegating Vale to second place. Vale used to use its dominance to set the price it wanted for iron ore, and watch while the others accepted Vale’s hegemony and fell into line. But the risk is that BHP Tinto will now call all the shots, and Australian ore can be delivered much more cheaply.

The greatest risk of all these shenanigans from the world’s iron ore producers is, however, that they will spoil the game for everyone. As the demand for Chinese steel subsides, it is China who is back in the box seat. Come 2009 the Chinese steel producers may well turnaround and say “We don’t really need so much iron ore this year, how about we offer you X for what you’ve got”.

And X may well be a lower price than that set in 2008. Indeed, a much lower price if the Chinese are not quite so desperate and the major producers have spent all 2008 really, really doing their best to p*ss China off.

Shares in BHP are now down 26% from their peak, and Rio’s are down 30%. Shares in iron ore pure-play Fortescue are down 50%. So are Vale’s. It is all to do with the bursting of the commodities bubble, and as a global recession looms closer to reality (that which has sent the US stock market into a tail spin once more) one is hard pressed to argue that this commodity price correction will prove merely fleeting.

Resource analysts are still still giving it a red hot go, nevertheless. Deutsche Bank, Credit Suisse and Goldman Sachs – to name three – are all still predicting a 20% increase in the iron ore price next year. Resource analysts are always behind the curve of course, because they only change their forecasts once a quarter. A Bloomberg survey also found six Vale analysts’ average 2009 share price target to be double what it is now.

Tell em’ they’re dreamin’.

The super cycle argument has not become defunct. The growth of the emerging economies is a story that will last many a year yet, and will ultimately see higher prices for commodities such as iron ore. But nothing ever goes up in a straight line. We have hit a correction in the longer term bull market story, and it could be a big one. This is the time the iron ore producers have chosen to attempt to squeeze China even further. One gets the feeling China might be about to pick up its bat and ball.

For the longer term investor, nevertheless, the steep falls in the shares of bulk commodity producers mean those shares are beginning to reach levels of sound longer term value. Anyone expecting a rapid return to the miracle of early 2008, however, or even the boom of 2004-07, may be misguided.

Click to view our Glossary of Financial Terms