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Vale SA’s First Quarter Results Reflect Weak Iron Ore Prices

The world's largest iron ore producer, Vale SA (NYSE: VALE  ) has released its first quarter financial results. The first quarter of 2014 saw a sharp decline in iron ore prices amid a slowdown in China, which consumes around two-thirds of global seaborne iron ore. Not surprisingly, this had a negative impact on Vale's quarterly results.

Weaker iron ore prices hurt Vale's results
Iron ore was one of the few commodities to post a gain last year. This was due to the fact that demand, mainly from China, exceeded supply. In fact, this has been the case for many years. As a result, iron producers such as Vale, Rio Tinto (NYSE: RIO  ) , and BHP Billiton (NYSE: BHP  ) have been ramping up production. But just when mining giants are ready to meet demand, the fundamentals of the iron ore market have changed.

A slowdown in China as the world's second-largest economy rebalances has meant that the increasing supply of iron ore starting this year is likely to create a glut. Morgan Stanley expects a supply glut of 79 million tons this year. The supply glut is expected to double to 158 million tons in 2015. An expected supply glut has hurt iron ore prices since the beginning of this year.

Weaker iron ore prices had a negative impact on Vale's first-quarter results. The Brazilian mining giant registered its lowest quarterly sales in four years in the first quarter of 2014. Jose Carlos Martins, who heads Vale's ferrous metals division, noted in a conference call that for the first time in the last 10 years that he has been tracking the iron ore market, there is a different situation in which supply has exceeded demand.

In the first quarter, Vale's average selling price for iron ore were only $90.52 per ton, well below what analysts were expecting. While average selling prices were expected to drop in the first quarter as iron ore prices fell, the drop was accentuated by negative effect of the reversal of price provisions recorded at the end of the fourth quarter of 2013.

Vale's first-quarter profit dropped 19% on a year-over-year basis to $2.52 billion. The company's first quarter profit also fell short of Street expectations of $2.59 billion.

Some positives
There were some positives in Vale's first-quarter results. The company's production reached 71.1 million tons, which is the best performance for the first quarter in six years. Vale also saw record production for nickel. Nickel prices have risen sharply this year even as other industrial metals have struggled. As I noted in a previous article, stronger nickel prices will benefit Vale.

Vale also saw strong demand for pellets in the first quarter of 2014, which allowed the company to charge higher pellet premiums. Pellet demand could remain strong as China looks to tackle its pollution problem.

Another positive for Vale was reduced costs and expenses as the company continued its cost-cutting measures.

Iron ore weakness remains the major worry
Despite these positives, the major worry for Vale and Australian miners Rio Tinto and BHP Billiton remains the weak outlook for iron ore prices. It must be noted that Vale has the lowest production cost. In the first quarter, the company's iron ore cash cost per ton, excluding iron ore from third parties, was $21.59.

However, after adding freight costs and depreciation, Vale's costs nearly double and are in line with those for Rio and BHP Billiton. Even with costs at around $45 per ton, Vale can easily remain profitable. But profitability is not the worry for Vale and other mining giants. The problem for them is that weaker iron ore prices would significantly reduce their cash flows and delay plans to reduce debt and increase shareholder distributions. 

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Varun Chandan

I have a Master in Finance degree from IE Business School in Madrid. I use the top-down approach when it comes to investing. I like to analyze macroeconomic factors and how they impact individual companies.

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