Investment Thesis
Vale S.A. (NYSE:VALE) and Rio Tinto Group (NYSE:RIO) enjoyed strong returns in January due to China's reopening, but the bull run was short-lived. As a result, I have booked profits for VALE and disposed of all my position after hitting my target price of $17. I consider that both stocks have reached their fair value with little upside potential from current levels.
Data byYCharts
Recovery In China To Boost Iron Ore Demand
The Chinese economy is poised to recover after the Government's recent initiatives, and there is clear room for Chinese base metals demand to rebound from the depressed level of 2022. I expect the combination of a more pro-growth policy stance from the Chinese authority and a quick rollback of COVID Zero measures to trigger a rebound in Chinese demand for basicmaterials throughout 2023. In addition, infrastructure investments continue to be rolled out, domestic manufacturing should pick up, and the Chinese Government has been taking action to shore up the property market, preventing a disruptive downturn.
However, the concerns around the property market dynamics remain, although the Government has been ramping-up support measures to bolster confidence and activity (e.g., providing liquidity for developers to finish projects, lowering restrictions for the market, lowering mortgage rates). In addition, infrastructure-led steel demand should continue gaining momentum into 1H23 as projects generate additional steel demand. At the same time, manufacturing geared toward the domestic market should also gain traction.
www.spglobal.com
Goldman Sachs recently highlighted that China's property market showed signs of recovery as home sales increased for the first time in 20 months in February. In addition, the top 100 real estate developers reported a 14.9% year-over-year rise in sales value. The bank suggests that this trend in property sales typically precedes an increase in construction starts, which drives higher demand for steel, which is a positive for iron ore demand.
Iron ore price is expected toaverage∼$120/t in 2023. Since 2019, prices have been supported by exceptional supply constraints: in Jan '19, Vale's Brumadinho accident led to the curtailment of Brazilian iron ore capacity, COVID and related supply chain constraints in 2020-21, delays to the ramp-up of new projects in Australia in 2021-22. Nevertheless, mining companies like Vale and Rio stand to benefit significantly from the tightening of the iron ore market and China's reopening.
Iron ore supply and prices typically have distinctseasonality, reflecting weather disruption in Q1 that affects Brazil, Australia, and China mine supply. In addition, the timing of China's Lunar New Year in Q1 since steel mills typically restock ahead of the period. I expect negative seasonality trends for iron ore prices to re-emerge in Q2-Q3 as capacity constraints improve, resulting in higher iron ore supply across 2023-24.
Bloomberg
Global Steel Outlook
Domestic steel demand to expand into 2023 from a weaker base. As stated above, the property market remains a concern and has significantly weighed domestic steel consumption. However, on the positive side, infrastructure-led steel demand should continue to gain momentum into 1H23 as projects begin to generate additional steel demand. In addition, manufacturing activity should also recover next year (admittedly from a low base in 2022). These factors likely propel steel demand and support profitability into next year. As a result, it is reasonable to expect Chinese steel demand to increase between2-3%in 2023 vs. 2022.
However, the ex-China outlook remains more challenging with tighter monetary policy in several countries that should weigh on economic growth in many key regions, hampering construction activity. At the same time, increased cautiousness on both the consumer and industrial sides should also impact manufacturing activity and, thus, steel demand. Supply has also been impacted by a more challenging macro scenario, with North American steel producers ramping up new projects at aslower-than-expectedpace. In Europe, soaring energy costs have led several producers to curtail production.
EV Transition - A Strong Tailwind For Metals
The shift from gasoline-powered cars to electric vehicles (EV) is crucial to achieving a net-zero future. The International Energy Agency'snet-zero pathway states that over 60% of passenger car sales worldwide must be EVs by 2030 to make progress towards achieving net-zero emissions by 2050. The transition towards EVs will significantly impact the demand for metals, but it is difficult to predict the exact timing and volume of this impact.
Several factors drive EV demand, including the regulatory environment, infrastructure development, customer acceptance, and the increasing mix of EVs for different use and range requirements. The demand for raw materials will also be influenced by battery chemistry, characteristics, and performance, determining the loading of metals such as nickel and cobalt per car. In the longer term, recycling will play a vital role in meeting the demand for metals, and companies like Glencore are already exploring opportunities in this space.
The choice of battery for an electric vehicle depends on the type of EV. However, lithium-ion batteries are the most commonly used batteries in EVs. The minerals required for these batteries may vary depending on the cathode's chemical composition, but essential materials such as lithium, cobalt, nickel, graphite, and manganese are needed to produce them.
Bloomberg forecasts a surge in demand for metals such as nickel, aluminum, and iron. This can be attributed to the growing popularity of EVs, as the production of vehicle batteries is predicted to increase by tens of millions over the next decade. Similarly, there will be a substantial rise in demand for other metals that play a crucial role in producing electric vehiclebatteries, such as lithium and graphite.
www.mining-technology.com
Vale Outlook & Guidance
Vale provided iron ore production guidance for 2023 to be within the range of 310-320mt vs. 310mt in 2022. However, Vale's management acknowledged underestimating the impact of the Brumadinho disaster on operations and the licensing process in Brazil, leading to adjustments in the production outlook.
Despite completing the construction of Torto Dam, it still lacks final licensing. The company has also encountered challenges in processing jaspilite/waste in the S11D project and improved its orebody knowledge. However, Vale is developing projects such as the +10mt and Serra Sul 120 to maintain production levels. Licensing restrictions for Serra Norte may result in high costs for the foreseeable future.
VALE's Stock Performance
After weeks of increases, following the iron ore prices that reflected the expectation of increased demand for commodity prices, the shares of Vale and the entire sector underwent a correction. However, the commodity's price still has maintained at a high level. On the other hand, Vale's management has recurrently emphasized its focus on sustainable mining, adding value to the ferrous minerals segment and strengthening its performance in base metals.
During the analyst call, Vale's management explained that selling a minority stake (up to 10%) would speed up Vale's plans to enhance the business and realize its full potential. The strategy is to operate the division as a self-sufficient growth unit. The proceeds from the stake sale are mainly used for advancing growth projects rather than returning capital to shareholders. This initial stake sale could be a precursor to further stake sales or an IPO.
In addition, despite the various projects in progress, the company maintains as one of its priorities the strategy of returning cash to shareholders through its policy dividend and buyback programs. Currently, the valuation of Vale is only around 4 times its earnings. Not surprisingly, the company's profitability will remain high this year due to high commodity prices. However, considering that iron ore prices should eventually return to normal, Vale's stock has reached its potential for this cycle.
Data byYCharts
Rio's Simandou (Guinea) Iron Ore Project
The Simandou project, located in Guinea, West Africa, is considered the world's largest and most advanced undeveloped iron ore deposit, with a grade of approximately 65% Fe. It is expected to produce more than100Mt per year, which could have significant implications for the long-term global iron ore supply and may potentially cause prices to decrease.
Simandou comprises two separate mine projects: Blocks 1 & 2, owned by the SMB Winning Consortium (Winning International, China Hongqiao, and UMS Guinea), and Blocks 3 & 4, owned 45.5% by Rio Tinto (and 39.5% Chinalco and 15% Govt. of Guinea). RIO stated that the term sheet is:
a pivotal next step towards securing the shareholder agreement, cost estimates, and regulatory authority approvals necessary to progress the co-development of rail and port facilities.
Rio Tinto
If RIO confirms a commitment to proceed, it could introduce a new risk profile to RIO's investment case. Specifically, project execution and CapEx risk for a major greenfield development over a ~3 to 4-year construction period, new and increased sovereign risk (Guinea), and potentially increased environmental, social, and governance risk factors. From a positive perspective, RIO's hypothetical involvement could offer it a natural hedge against future disruption to global iron ore markets/supply and likely lower long-term prices, given RIO's equity interest in the project.
RIO is participating and negotiating with other project stakeholders to advance the project's scope, feasibility, cost, environmental and social challenges, and potential financing structures. The greenfield Simandou, iron ore project is expected to be approved later this year once the agreements have been finalized, potentially by the end of H1.
A Capital Intensive Industry
RIO has historically been one of the highest dividend-paying mining companies. However, RIO's percentage and U.S. dollar billion payout is at risk of decreasing in 2023/24 due to the risk of a decrease in iron ore prices and competing capital commitments, particularly capital expenditures. RIO has estimated that its capital expenditures will bearound$9-10 billion in 2024/25 and reaffirmed its plan to spend $7.5 billion to reduce Scope 1 & 2 emissions by 50% by 2030E. RIO stated that approximately $4 billion of its 2023-25E CapEx guidance would go towards its share of the project. Additionally, RIO hinted that Oyu Tolgoi would require over $1 billion in the capital in 2023.
Data byYCharts
RIO's stock has performed well, rising 28% since November 2022 and trading at a higher EV/EBITDA multiple than the historical one. This is primarily driven by positive factors such as China's reopening and seasonal support for iron ore prices in Q1. However, looking at a longer-term horizon, it may be wise to sell before China reopening sentiment fades and seasonal downside impacts iron ore prices in Q2/Q3. Furthermore, the current valuation of RIO is expensive compared to its historical cycle. Therefore, taking advantage of the current share price strength and selling before downside risks emerge may be prudent.
Data byYCharts
Iron Ore Production In 2023
One of the biggest iron ore producers in the world, the Brazilian company Vale, aims to produce more than 360 million tons of iron ore year by 2026, which suggests a CAGR of around 3.8%. In addition, the company forecasts its production level to reach anywhere between 310-320mt in 2023.
Similarly, RIO's Iron ore output increased by 6% to 89.5 Mt, and iron ore shipments increased by 4% year over year to 87.3 Mt in the fourth quarter of 2022. As a result, the iron ore shipments in 2022 reached321.6Mt, unchanged from the previous year. Due to the ramp-up of the new 45 mt Gudai-Darri mine by mid-year and the solid start with shipments, Goldman Sachs estimates that it will produce 335 mt in 2023.
Rio dethroned Vale in 2019 following Vale's dam breach disaster, and based on the forecasts, Rio will remain slightly ahead in 2023.
Bloomberg
Conclusion
Vale S.A. and Rio Tinto Group were beneficiaries of China's reopening and rising iron ore demand, and their stock prices have seen a spike in tandem with iron ore prices throughout the cycle. However, at the current levels, there is limited upside potential. Nevertheless, considering the cycle and normalization effect after a strong bull run, investors might consider investing in both stocks if prices fall by 20%.
$Vale SA(VALE)$ $Rio Tinto PLC(RIO)$
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