New Supply Deal Doesn't Solve Cliffs Natural Resources' Problems

Cliffs Natural Resources secured a supply deal with ArcelorMittal, but the weakness of its Canadian operations and the drop in iron ore prices will pressure the company.

Mar 1, 2014 at 9:52AM

Cliffs Natural Resources (NYSE:CLF) recently announced an agreement with ArcelorMittal (NYSE:MT) to supply iron ore pellets for an additional two years through January 2017. This is good news for Cliffs Natural Resources, as it prolongs the life of its Empire mine, which didn't have a customer for pellet production beyond 2014. However, the major problems pressuring Cliffs Natural Resources remain intact.

Iron ore prices continue to drop
Iron ore prices recently dropped below $120 per ton, extending their declines. This move came amid the slowdown in demand from Chinese steel mills, which are being affected by credit tightening in the country. Demand from China is the pillar of global iron ore demand, and it significantly impacts iron ore's price.

Meanwhile, supply continues to rise, fueled by record output from mining giants like Rio Tinto (NYSE:RIO). Rio Tinto generated 47.6% of revenue from its iron ore business in 2013. The company continued to invest heavily in iron ore, spending almost $7 billion on capital investments. Rio Tinto is playing a dangerous game, as its efforts to increase production add more supply to an already oversupplied market.

All in all, it looks like Cliffs Natural Resources will get no mercy from iron ore prices in the near term. In this environment, cost efficiency is a must. This is the area where the company has certain problems.

Canadian operations underperform
The contract with ArcelorMittal was secured for the best-performing part of Cliffs Natural Resources' business -- its U.S. operations. No wonder activist shareholder Casablanca Capital proposed to separate U.S. operations and the rest of Cliffs' business by dividing the company into two parts. However, the future of Cliffs' international operations in a separate entity looks grim, so the company is unlikely to make such a move.

While the cash cost for producing iron ore for U.S. operations was $65.71 per ton, the cash cost for its Canadian operations was $110.03 per ton. The company expects to lower the Canadian segment's cash cost to $85-$90 per ton in 2014.

However, it's likely that Canadian operations will continue to perform with negative margins. There are several reasons for this. First, to get the cost of sales we have to add depreciation, depletion, and amortization to the cash cost, and it was $22.27 for Canadian operations in 2013. Second, iron ore prices continue to fall, and Cliffs' realized prices are typically below benchmark prices.

Bottom line
The situation continues to be challenging for Cliffs Natural Resources. If softness in Chinese demand continues, it will put additional pressure on iron ore prices. This softness is also uncomfortable for Cliffs' Australian operations, as China is the main importer of iron ore from the country.

On the other hand, Cliffs Natural Resources trades at 60% of its book value, and the company's stock has already lost more than 20% year to date. Many of the negative factors influencing Cliffs' business might already be reflected in its share price.

If iron ore prices fall further, smaller producers will start to quit, easing the supply situation. Cliffs could weather the storm, but its share price will remain under significant pressure in the event of further deterioration in the iron ore market.

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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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