Tuesday, August 24, 2010

Barclays on iron ore pricing

Iron ore spot prices downtick: Last Friday, the Platts IODEX (CFR China, 62% Fe content) closed at US$146.5/dmt, down c1% d/d. This marks the first drop since July 14th. While the new quarterly pricing mechanism resulted in higher realized prices for the miners, it also increased volatility. In our view, this is a new feature of the iron ore market, which investors will have to adapt to. From June to August 20, the average spot price (IODEX) is currently at US$136/dmt, implying downside of c15% q/q for 4Q10 contract prices. A steeper cost curve of the marginal producers (China/India) combined with a critically tight seaborne market during the next 2-3 years should result in well supported iron ore spot prices above US$120/dmt, in our view.

At the current forward iron ore pricing curve, Vale looks attractive: Examining FIS forward curves, 2011 contracts for iron ore (62% Fe, CFR Tianjin) and freight (Tubarão- Beillun) are quoted at US$126/dmt and US$24.5/wmt, respectively. Plugging these parameters in our model, Vale would be trading at close to 6x EBITDA, below its normalized EV/EBITDA multiple of 7x. If our seaborne S&D analysis proves correct, the market should be even tighter in 2011, and iron ore prices may surprise on the upside. We reiterate our view that 2010 is not the peak of the iron ore cycle.

Crude steel production (CSP) in China recovering: After stabilizing at the end of July, Chinese CSP showed the first signs of recovery during the first ten days of August. According to preliminary figures released by China's Iron and Steel Association (CISA), the average daily steel output during the period was 1.72Mt, up c5% from the previous ten day period. This result is mostly explained by the end of maintenance works at steel mills and higher prices in the Chinese domestic steel market.

Brazilian Steels: Testing the impact of structurally lower margins: Recently, we have heard from industry players that long-term EBITDA margins for the Brazilian steel makers may be declining to 20% (non-integrated in iron ore). In our view, a long-term margin of 20% (EBITDA) looks aggressive, but if true, would be highly negative for the sector. In our valuation models, we already assume a compression of the domestic steel pricing premium, and normalized EBITDA margins at >30% levels. We acknowledge that the Brazilian steel market is experiencing a structural change, especially with regards to steel imports and the competitive environment. Assuming sustainable 25% EBITDA margins (for steel divisions only) would imply downside potential from current levels of: -17% for Usiminas; -12% for Gerdau and -6% for CSN.

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