2023-07-03 12:56:01 ET
Summary
- China's COVID reopening has not led to a strong economic rebound, and the downside risks for iron ore demand are not fully priced in by the market.
- Declining new property development in China could lead to a massive decrease in steel and iron ore demand, potentially causing iron ore prices to fall to previous cyclical lows.
- Oversupply could push iron ore prices to $50-60/ton, significantly decreasing Vale's net income/EBITDA to levels comparable to 2015/16 lows, potentially driving stock price to previous cycle lows.
China’s COVID re-opening has not led to the strong economic rebound that market participants were still optimistic about in Q1-2023 - by Q2-2023 this optimism gradually faded, for example:
- Goldman's analysts warned that the property sector weakness may be a drag on Chinese growth for many years.
- Chinese economist (who formerly served as IMF official) stated that a massive stimulus is not coming.
The reopening of trade has given way to uncertainty. As shown below, VALE stock price surged from c.$11-$12/share in Q4-2022 to $18-19 in early 2023 on strong expectations from China’s COVID re-opening and has since declined to $13.
Where might Vale head from here? This article argues that there are significant downside risks as key negative factors impacting Chinese iron ore demand are currently not fully priced in by the market.
Vale: financials driven by iron ore (c.80-90% of revenues and EBITDA)
Vale financial results are mainly driven by its iron ore business:
- Per the FY15-22 annual report below, Vale’s revenues were 70-80% generated from its “Iron Solutions” segment (which is substantially iron ore and related products) with 20% from nickel and copper (grouped under “energy transition materials”).
- Iron solutions were generating substantially all of EBITDA (the other segments include energy transition materials and other G&A costs that roughly balance out).
The predominant driver of Vale’s financials has been iron ore prices, as iron ore production volumes have been relatively stable. Iron ore prices have swung wildly in the past decade, as shown below:
- when prices averaged $44.6/ton in 2015, Vale iron ore adjusted EBITDA was $5.9bn,
- while when iron ore averaged $141/ton in 2021, iron ore adjusted EBITDA was $31.1bn.
iron ore price (investing.com)
Iron ore prices driven by Chinese demand
Iron ore prices have mainly been driven by Chinese demand, which accounts for 57% of total global demand in 2022 and roughly 70-80% of global iron ore imports. According to market estimates, c.35-40% of Chinese iron ore demand comes from real estate. The shift in China’s economic priorities from GDP to a bigger emphasis on balance and security has a mixed impact on different sectors, especially on real estate. Real estate ( which accounts for 20% of the Chinese GDP, even according to Chinese sources , which tend to downplay real estate’s significance) was hard hit in 2022.
As shown below, Australian government/World Steel Association estimates Chinese steel production will flatten in the next 5 years (compared with an increase from 400 million tons in 2006 to 1 billion tons in 2020) and Chinese iron ore imports will slightly decrease.
china steel production (Australian government)
china iron ore imports (australia government)
Based on this projection, Australian government estimates long term iron ore prices to be around $63/ton by 2028.
iron ore price outlook (australian government)
The underappreciated downside risk that we'd like to highlight is that declining new property development in China will massively decrease steel and iron ore demand, that may lead to an even faster and sharper decline in iron ore prices (to perhaps even previous cyclical lows seen in 2015-16).
While Chinese has issued policy after policy supporting the property market starting late 2022, these measures have not had much effect:
- Many Chinese property developers saw their bond prices decimated in 2022, which saw $63.7 billion of defaults of dollar-denominated high yield bonds ). Property developers like Wanda etc that were considered investment grade and had relatively stable bond prices in FY22, are now seeing the price of those bonds plummet this year as shown below.
- New property sales have been anemic: as shown below the new property sales for 30 large and mid-sized Chinese cities, the brown line is 2023 and is not much higher than 2022 (when there were repeated COVID lockdowns) and much lower than 2020 or 2021.
china new property sales (Zheshang securities)
- New area that begun development (yellow line below) per official figures are actually down 21% in YTD Apr-2023 compared to same period last year (which was impacted by COVID and saw a 40% decline YoY). This suggests developers just aren’t building new houses, and this is likely a leading indicator of steel/iron ore demand for several years.
Chinese property development YoY (Anjuke research)
- To give some perspective, at year-end 2022, China had 9 billion square meters of real estate under development (roughly 6 billion are residential), whereas 600 million square meters of residential real estate completed construction in 2022. So it appears that real estate developers can continue building existing projects for a decade without starting anything new. With overdue debts to pay and a decade of projects to complete, developers are in no hurry to start anything new, which will negatively impact iron ore demand.
Many analysts have tried to explain the reason behind these trends, to give a flavor of some of the explanations:
- Some suggest Chinese households are becoming more pessimistic towards their income and housing prices due to a worsening employment situation (especially for well paid jobs, as Alibaba have taken the headlines in their layoff programs ) .
- Others suggest it is because of an aging population with lack of new births , which has been extensively covered in the media already.
- Whatever the reasons, demand for new properties have been anemic and new property development has fallen rather than stabilized.
China iron ore demand was roughly 1.4 billion tons in 2022 (of which 1.1 billion tons was imported (c.75% of global seaborne volumes as shown below) and 300 million produced domestically)
global seaborne iron ore volumes (statista)
Seaborne iron ore prices (which are mainly influenced by China’s imports) would face pressure from both lower demand and higher supply:
- Demand: If iron ore in property development declines by 50% in China (leading to 20% decline in iron ore demand) iron ore demand may fall 300 million tons, of which domestic production may decline by 100 million tons/year (to its 2016 lows) and imports may fall by 200 million tons/year.
- Supply (specifically export volumes) is forecast by Australian government to increase by 3% a year in Australia and Brazil and globally as well. This would be c.50 million tons a year in additional supply, despite potentially declining demand.
- The long term supply situation is even more worrying: Supply may also face large increases from Simandou (a project in Guinea that may potentially increase annual supply by another 100-200 million tons/year, though the project has faced numerous delays and commercial production is expected to start in Q2-2025 and ramp up in subsequent few years.
- Given the tendency for commodity markets to overshoot (the same iron ore), the above could cause prices to fall to the marginal cost of production at around $50/ton. As shown below, if demand of seaborne iron ore declined by a few hundred million tons, the marginal cost of production would be near $50ish/ton. Once supply evidently exceeds demand and the medium-term forecast is oversupply, producers will try to produce and sell as much as quickly as possible, which will have the overshooting effect.
global seaborne iron ore cost curve (Macquarie)
- Markets and particularly commodity markets have a tendency to overshoot when surplus is evident and expected to persist indefinitely. For example, oil spent months at $20-$30/barrel during periods of oversupply in 2016 and were even momentarily negative in 2020, despite the fact that such price levels were below the marginal breakeven production cost and the price had to go up at some point. Iron ore prices could also fall to a price which is breakeven for a substantial amount of miners (which would be very close to Vale’s cost per above chart).
Impact on Vale:
As shown below, when iron ore prices averaged $44-$66 in 2015-2018, adjusted EBITDA from iron ore was $5.9-$14.7 billion a year, which doesn’t seem too bad.
Vale financials detailed (20-F)
But the cost of iron ore fines per ton has increased dramatically, averaging $27.5/ton in 2015 and $45.8/ton in 2022.
According to Management, 63% of its iron ore sales were to China in 2022 (Asia: 77%), Management included a breakdown of breakeven costs to land in China (a good proxy for overall Asia as well). This appears to indicate the breakeven costs after considering sustaining investments was somewhere near $30+/ton before 2019 and has crawled to near $50/ton now (Management forecasts $47/ton before considering sustaining investments in 2023). Overall, costs increases have been attributed to higher operating costs after the Brumadinho event in 2019.
iron ore cost breakdown (Vale website)
Vale's competitor Rio Tinto has demonstrated similar cost trends with unit costs increasing from $29.5/ton in 2019 to $39.7/ton in 2022 (which Rio Tinto's annual report attributed to inflationary pressures from wages, energy etc)
rio tinto cost fy19-22 (rio tinto annual reports)
Assuming iron ore breakeven EBITDA costs meet the forecast of $47/ton in 2023, and prices were $65/ton, this would earn a margin of $17/ton, similar to that of 2015. Assuming Vale could earn the same $7bn EBITDA as it earned in 2015, after deducting $3bn in sustaining capex (average from FY15-FY22), this would leave only $4bn, compared with an enterprise value of $72.5bn (per seekingalpha)
If iron ore prices overshoot and fall to or below the marginal cost level for Vale, then Vale earnings would be even lower, and its current market cap would be even harder to maintain.
Summary:
If Chinese real estate demand for steel/iron ore falls dramatically (as the new property development data suggests), oversupply as well as the persistent expectation of oversupply could push marginal costs to $50-60/ton, which would massively decrease Vale’s net income/EBITDA (pick your metric) to levels near or below that of 2015/16 lows.
For further details see:
Vale: Downside Risks As Chinese Demand Weakens