Wednesday, November 14, 2012

Iron Ore and Three Companies to Avoid

Iron ore is one of the most important natural resources. It is a raw material to produce steel, the most commonly used metal in the world, accounting for more than 95% of metals used per year. The price of iron ore has experienced a nice run up in several years. At the end of 2008, the iron ore price was around $60. It shot up to more than $170 in the second quarter of 2010, reaching the top of nearly $190 in the first quarter 2011. However, it has experienced a gradual decline to $114 now. With that high volatility in iron ore pricing, should investors buy or sell iron ore? What should we do with commodity companies, which are involved in iron ore/steel making activities?
First, let's have a look at iron price's chart from 2009. It experienced a nice increase and has been trending down. 
Looking at a longer horizon, it is the most booming period over the last 20 years.
However, the trees can’t grow to the sky. Everything should follow the common nature of economics, supply and demand. Several global steel companies have warned investors about the demand slowdown in global iron ore demand. On 30th August this year, Baosteel’s senior executive said that as supply kept rising, the global iron ore demand might drop in the second half of this year. That would put the downward pressures in steel and iron ore prices. BHP Billiton (NYSE: BHP), the biggest global miner, commented that iron ore demand from China has slowed down by more than 50%. Alberto Calderon, BHP’s chief commercial officer said: “Demand will grow less, although still quite impressively and the producers, in general, are more prepared. This doesn’t mean that the boom has ended, but it does mean to expect that prices will grow or even stay at very high levels, you would do it at your own peril.”
David Einhorn, one of the famous short-sellers and hedge fund managers, also showed his bearish attitude towards the iron ore as he selected it as one of his short targets. He said that the higher prices would attract everybody in the field, with new players and new supplies, and there would be a huge amount of supply, which was going to be online in the market. Iron ore is the main raw material for steel production. Einhorn thought that the last year which steel had double-digit growth in its demand was 2010. There would be big projects built in 2010/2011 were coming into the field with massive supplies, and of course, the projects couldn’t be postponed as it would cost project owners a lot of money. That would cause the significant declines in both steel and iron ore prices. Deputy director at Lange Steel Information Research Center, Wang Guoping predicted that the imported iron ore prices might fall to $70 a ton next year. It was reported by China Daily that many Chinese iron ore producers stopped their production, stockpiled a huge amount of iron ores across the country.
Because of the pressures in iron ore and steel market, several global producers would take a hit, including BHP, Vale (NYSE: VALE) and The United States Steel Corporation (NYSE: X). Those three companies were in the “loss list” of Einhorn as well. BHP produced nearly 39.77 million tons of iron ore in the quarter ended September 2012, marking a year-over-year growth of 1% but a sequential decline of 3%. However, BHP has a strategy of diversifying its commodities. As of fiscal 2012, iron ore’s revenue was $22.6 billion, accounting for 31.3% of total revenue. BHP is trading at $71.22 per share; the total market capitalization is $114.36 billion. The market is valuing BHP at 12.3x P/E and 2.9x P/B. In contrast, iron ore has made up a big chunk of Vale’s operating revenues. Sales of iron ore and iron ore pellets were $43.1 billion, accounting for 71.5% of total revenue in 2011. Vale is trading at $18.10; the market capitalization is $93.28 billion. The market is valuing Vale at 4.5x P/E and 2x P/B. United States Steel has three main steel products: flat-rolled, USSE and Tubular with total sales of $19.7 billion in fiscal 2011. It has been a constant dividend payer with 5 cents quarterly dividend since 2009. The share is trading at $21.10; the total market capitalization is $3.04 billion. Currently, US Steel is valued at 0.8x P/E in the market. Because it has trailing twelve month losses, so its P/E is not valid. 
My Foolish Take
Personally, I think iron ore is the commodity to be shorted in the future, until the iron ore and steel market is in equilibrium or towards demand shortage again. Among the three companies, BHP seems to be the least exposed because of its commodity diversification strategy. However, the overall iron ore supply/demand has prevented me from making a bet in this field.

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