RIO - Getting the Most Value for Your Product

Implications: 1.  Timing of CVRD announcement is rather odd with record iron ore inventories and steel prices beginning to slide in China. 2.  Longterm mismatch between iron ore supply and steel demand not readily apparent in today's market. 3.  The gap in vessel freight spread between Brazil and Australia into Asian customers has narrowed. 4. True value is in the product itself.  Best way to optimize this value is to sell to the highest bidder. 5.  Benchmarking pricing sytem is outdated.  Selling ore to highest bidder could possibly lead to an index or swaps market.

Analysis:  The timing of CVRD’s announcement to raise iron prices comes at a very precarious time with record iron ore inventories and steel prices beginning to slide in China.  Actually, it must be clarified that CVRD is not trying to raise prices.  They are actually trying to recoup the discount they give Asian customers for the higher vessel freight rate they have to pay to ship CVRD’s ore from Brazil than the lower vessel freight rate paid by the Europeans. Even CVRD has acknowledged themselves that there is no guarantee they will be able to convince their Asian customers to agree to this price “equalization”, which amounts to an increase of 11-11.5 % higher than what the Asians are currently paying.  

Many analysts cite the mismatch between iron-ore supply and steelmaker demand, which will help to justify Vale's case and make it not totally impossible to achieve the “one price for all” concept they are proposing.  However, with iron ore inventories setting weekly records, steel pricing already coming off in China and a backdrop of a world economy that certainly seems to be slowing, especially based on action seen in the equity markets this week, the longterm mismatch between supply and demand is not as clear today as it was the last 5-6 years leading up to the Olympics.  Steel demand will most likely grow this year, but at what pace?  It does not seem that it will meet the levels of  6 % annual growth that we have seen over most of the last decade. Also, the longterm mismatch is not readily apparent in today’s market when the Chinese are staring at following situation today: According to Chinese statistics, China produced about 200 million of their own iron ore production during the 1st half of 2008  plus the import 230 million tons in the first half and the total iron ore supply was 430 million tons. But meanwhile, China’s pig iron production was 247.7 million tons which only  requires 396.3 million tons of iron ore, which based on those figures creates an oversupply of 33 million tons of iron ore.  Considering the high iron ore inventories, close to 2 months of lost steel production due to Olympics/Paralympics, weakening steel pricing and speculation in the Chinese market that an Australian supplier has the plan to supply 50 million China, therefore it looks like the iron ore oversupply situation would be maintained until the end of this year.

Vale believes it merits increased prices not only because it has higher grade iron ore but also because the freight differential Brazil-China and Australia- China has narrowed significantly in recent months.  Brazil had previously accepted a lower price for shipments to Asia because of the higher freight price.  This is a common practice in the trade of raw materials for steelmaking, as the same holds true in many instances for Australian coking coal versus US coking coal, where the Fobt price of the US coking coal is higher due to the lower freight rate.  In fact, the same price relationship exists with Chinese met coal being sold to Japan at a higher Fobt than the Australian coking coal Fobt price being sold to Japan.   Nevertheless, vessel freights have decreased worldwide for that matter, so why not ask the Europeans for a price increase as well?  The reason Vale will not succeed in their request to have one Fobt price is mainly because all steelmakers worldwide booked the majority of their vessel freight needs, if not all of it, earlier this year when iron price were settled.  How can the Asians or any steelmaker give back a freight savings that may not exist?  

Vale’s better argument for a uniform worldwide price is the true value of the product itself.  Why Vale would ever give a discount for a longer vessel haul does not make much sense when one considers they have the highest iron ore content in the world with its superior Carajas product.   If one wants to talk about a mismatch in supply and demand, this is where it is at.  There may be an oversupply of iron ore in China, but how much of this material has the high iron content that CVRD’s ore offers?  I would further bet that most of the oversupply in iron fines I mentioned previously comes from India, which has a much lower iron content and the reliability of consistent supply and quality can also be thrown into the mix when discussing ore from India. I have said for a long time that the best way for Vale to optimize the true value of their ore is by selling it the highest bidder in the market.  I’m not proposing a complete dismantling of the current benchmarking system.  Yet, when one has a product that no one else has and everyone wants, it seems foolish to sell 100 % of your production at a set price just to be safe and in order to lock in costs, revenue and profibality .  No doubt that what I’m proposing comes with risk.  If Vale set 30 % of their production aside to sell to the highest bidder in the market, the price difference between the contract price and spot price could be a lot more and lead to lower earnings.  It would be harder for Vale to estimate what to report to shareholders each quarter and it might not be pleasant what Vale would be reporting.  On the flip side is a company leaving a hord of cash on the table.  As an investor I would rather have a company take that risk to make more money for me than see it go in the pockets of their customers.  Based on my research since 2004, the Indian spot CNF price to China vs the Brazilian CNF contract price (using spot freight rates) has only gone below the Brazilian contract price 3 times and very briefly, ie less than 1-2 months.  In each instance, the difference in price was less than $5/MT.   Over the least 5 years, the spot price for Indian iron ore fines has been a lot higher than Brazilian iron ore fines.  To give one an example, this year alone when the Indian spot price reached $210/MT, the Brazilian price for a far superior grade of ore was $160-165/MT.  If left to the open market and seeking the highest bidder, there is no doubt that Brazilian iron ore would have fetched at least $220/MT.  Who knows what the limits are?  It may have fetched as high as $250/MT.  We do not know, though, since it never has been tried.  Only then would we and even Vale know the true value if their product in the marketplace.  I've got a feeling, though, that they would be pleasnatly surprised.  

The benchmark pricing system is outdated.  Part of the reason Vale wants a uniform price is that they rushed to settle on their price with the Asian steelmakers and got a lower price than their Australian counterparts this year.  If Vale sold 30 % of their production in the spot market, they would have easily made up the difference lost in the price concession for the higher freight rate to Asia and then some.   Selling iron ore to the highest possible bidder on a certain percentage of  production could also possibly lead to an indexing or swaps market.  The seller would now have the ability to hedge the risk of a falling market for the commodity itself and vessel freight.  This would also benefit the risk the steel mills take on receiving iron ore from any supplier to their bottom line, ie natural disasters where the seller cannot ship,  and now steel mills would be able to hedge against the price of spot Indian iron ore fines as well.  We are a long way off from a swaps iron market.  I do not know if there are enough players to make this a liquid market as well, but who says that it could not develop into this?  What  I think Vale should do today is take on a little more risk.  However, with a little more risk I am certain will come a lot more reward.  This is the best way to optimize the value of the superior product and dominant position Vale has in the market.