Better Outlook for Iron in 2014: Should You Buy?

As you know, demand for raw materials used in steel production is mostly driven by rapid industrial growth in China. And, although iron ore prices have dropped in 2014 so far, Credit Suisse is contemplating a scenario in which Chinese steel production reaches 840mt in 2014, with iron ore prices around $120/t. So, the outlook is fairly positive.

Two drivers might push iron ore prices up: pollution controls in China is pushing premiums for pellets, lumps, and higher quality ore; freight rates prices, especially Brazil-China freight, have dropped. In this context, and considering that the world will experience a 4% growth in steel consumption in 2014 following a stronger recovery in the American construction and automobile sectors, it would be interesting to analyze which companies are better positioned to profit from iron ore production. Here are three.

Expanding
First, we have the largest producer of iron ore pellets in North America, Cliffs Natural Resources (NYSE: CLF  ) . 

Driven by cost reduction measures in SG&A and exploration, as well as higher iron ore pricing, third-quarter results brought higher profits. Sales margin grew to $349 million with iron ore sales volume decreasing 2.5% to 11.7 million tons -- decent news, but not overly impressive.

Cliff is expanding at the Empire and Tilden mines, and increased its ownership from 70% to 100% in the United Taconite mine in Minnesota. With about 64% of the company's blast furnaces running currently in North America, iron ore production capacity is expected to increase. Moreover, its acquisition of Wabush mine will expand Cliff's international exposure, and add 6.4 million tons of iron ore pellets to its annual production capacity.

However, weak pricing for coal products is putting its North American coal segment under pressure. The division suffered a 23% drop in revenues on a per ton basis the most recent quarter.

Finding demand for its ore
Second, we have Brazil-based Vale (NYSE: VALE  ) , a huge player in the iron ore industry.

Third-quarter results improved year over year for Vale, with earnings per ADR up 59%, and revenues climbing 11% to $12.9 billion.

The company is increasing its production of most of its metals, and, given the momentum of its research and development projects, we should see more expansion coming up. In fact, this last quarter Vale shipped 83.6 million tons, the third highest for the quarter in history. Plus, its cost-reduction program, which involved heavy divesting of non-core assets, will increase profitability.

Although rising demand in Brazil is giving Vale a geographical advantage, rising operational costs pushed by mining cost inflation puts a cap on margins.

In good shape
Finally, we have the diversified natural resources company BHP Billiton (NYSE: BBL  ) . The company produces lump and fine iron ore product in Australia, and iron ore pellets in Brazil.

Better than anticipated performance in Pilbara, Australia led to a stronger than expected first quarter 2014. Iron ore output reached a record 46 million tonnes in the region, and if we add its Samarco production in Brazil, total forecasted production for 2014 arrives to 192 million tonnes.

Considering that iron ore generated almost 60% of BHP Billiton's earnings in fiscal 2013, this year could drive more profits for the company. BHP Billiton managed to get lower-cost volume gains, which is not easy in this industry, and committed to a 'substantial' increase in free cash flow to be destined to increase shareholder return.

Final thoughts
Despite some improvements, Cliffs still presents excess capacity. And, if we consider coal's current prices, increased profitability will take time.

Considering the increasing urbanization taking place in Brazil, and the fact that high quality ore and pellets are finding good demand in China due to higher standards, we may see higher than expected realized prices driving earnings surprises for Vale. Pay attention to rising costs and profitability, though.

For similar reasons BHP Billiton's operations in Brazil might experience a boost. The company is well-positioned to profit from iron ore this year.


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