Plunge in Iron Ore Prices Sets Up Bounce Trade in Vale

05/20/2014 4:30 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

MoneyShow's Jim Jubak thinks that the iron ore price drop today could set up a trading bounce for one particular Brazilian iron ore and nickel producer.

A metric ton of bad news today ought to be good for a trading bounce in Vale (VALE). The Brazilian iron and nickel producer is a member of my Jubak’s Picks portfolio with a target price of $19. I think you’ll have to wait for a clear turn in the Chinese economy in the second half of 2014 to see $19—China consumes about two-thirds of the world’s seaborne iron ore—but the really bad news on iron ore prices today is likely good for a trading bounce back to $15 or so. (The New York traded ADRs hit that price on April 8.) That would be good for a 15% gain.

Today, the price of 62% iron ore delivered in China fell to $97.50. That’s the lowest price since 2012. The price had been $120 a metric ton as recently as April 9. Analysts have been busy cutting their forecasts of iron ore prices to $100 a ton for the third quarter of 2014.

The culprits in the price drop are something old—a big drop in demand from China as the Chinese economy slows—and something new—a fear that China’s steel makers have been importing more iron ore than they actually need, in order to use those supplies as collateral on loans. China’s steel makers are searching everywhere they can for cash since most are currently running at a loss and face the need to refinance piles of existing debt.

Vale’s average realized iron-ore price fell to $90.52 a ton in the first quarter of 2014 from $112.97 in the fourth quarter of 2013.

Big low-cost producers such as Vale, BHP Billiton (BHP), and Rio Tinto (RIO) are profitable at these prices. (Morningstar estimates that Vale’s cost is $22 a ton and that it costs another $20 a ton to ship ore from Brazil to China.) But many of China’s small producers aren’t. Estimates say small Chinese miners have already shut down 150 million tons of production with more to come. That would be enough to send iron ore prices higher over the next few years except that the big global miners are in the midst of big increases in production. Vale, for example, is scheduled to increase production to 450 million tons a year by 2018 from 300 million tons in 2013.

The big positive wild card for Vale in 2014 is nickel. (The company is the largest producer of nickel in the world after Russia’s OAO Norilsk Nickel.) Big nickel producer Indonesia has slapped a ban on nickel ore exports in an effort to get nickel miners in that country to do more value-added processing in Indonesia before export. Nickel prices are up 3% this year—despite worries about Chinese demand for the metal used to make stainless steel. The Indonesian ban will move the global nickel market into deficit by 2015 from a current surplus, according to Barclays. The global surplus will shrink to 41,000 tons in 2014, Barclays projects from a surplus of 181,000 tons in 2013. Nickel will then move to a 36,000 deficit in 2015. That will be the first supply deficit since 2010.

In February, Vale projected that nickel prices would continue to climb in 2014, although price increases in 2014 would be restrained by big stockpiles. The faster increase will come in 2015 when prices could hit $20,000 a metric ton, the company said.

That projection has turned out to be very conservative. Nickel prices jumped another 6% on May 19 to $20,110 a metric ton. I doubt that nickel prices will continue their meteoric rise—nickel prices were just $14,314 a ton at the end of February—and I wouldn’t be surprised at a pullback in the near-term. But I think the $20,000 level is a good bet for last half of 2014 and 2015.

Vale should see rising margins in its nickel operations even without a price increase. It opened its Totten nickel mine in Ontario in February. That will allow Vale to replace declining and higher cost production at its older mines.

I think those fundamentals will kick in later in 2014 to drive the stock toward my $19 target price. In the meantime, look for that bounce.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of Vale as of the end of March. In preparation for closing the fund at the end of May, as of the end of March I had moved the fund’s holdings almost totally to cash.

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