Vale (NYSE:VALE) has an envious cost position in the iron ore market, a sector that accounts for roughly 70% of the company's sales. Although it's far away from future demand centers, it's working to reduce that impediment and investing in the downturn as it awaits the next upturn. If things work out as planned, Vale could see its stock rise materially when iron ore rebounds.
A matter of cost
Vale is in the lower quartile of the iron ore production cost curve, an enviable position to say the least. It means Vale can produce iron ore for less than roughly 75% of its competitors. That's great during lean times like the ones the iron ore industry is currently facing. As prices fall during a downturn the most expensive production is usually closed first. That's particularly notable now, since the downturn is being driven by supply -- not demand.
Thus, Vale's low cost iron ore can gain market share as higher cost production falls off. However, the real positive here isn't surviving the downturn, though that's a notable benefit of being a low-cost miner, it's positioning for the upturn. As iron ore prices recover, Vale will benefit from higher prices more quickly than competitors and be selling more iron ore, a double benefit as margins expand.
Going where demand is
One big problem that Vale faces, however, is transportation. The big demand centers are expected to be in Asia -- Vale operates largely out of South America. How big of an issue is this? In the second quarter, China, a 45 day boat ride away, represented roughly 35% of Vale's sales. Since many competitors are sourcing materials from locations like Australia, which is only 15 days away from China, that's a competitive disadvantage.
But management is well aware of this. As such, it has been investing in giant Valemax ships. These are the largest ore carrying ships in the world, lugging 400 thousand tons of ore a trip. The goal is to have 35 in operation by the end of 2014. How big is this ship? According to Vale, a Valemax can carry 2.3 times as much as other ships in its category.
Being able to carry more ore has many benefits, not least of which is it cuts transportation costs. However, it also means a greener planet, since Valemax ships emit roughly 35% less carbon dioxide than comparable shipping options. In other words, Vale is working hard to make distance a less concerning issue. And it's getting more and more efficient as it expands its Valemax fleet. That helps to mitigate one of the main competitive problems currently facing the company.
Building for the future
Although iron ore prices are currently weak, the world's emerging economies haven't stopped emerging. And that means increasing demand for the raw materials needed to drive economic growth, like iron ore. That's why Vale expects demand to keep moving higher despite currently weak prices. Vale projects that Asia will drive a global increase in seaborn iron ore demand of nearly 35% between 2012 and 2020.
Vale is getting ready for this demand now, by investing in new, low-cost production. Vale's production should grow from around 300 million tons in 2013 to 450 million tons by 2018. That's currently costing Vale a lot of money and, with prices low, looks like a questionable investment. However, it takes a long time to get a mine up and running. By spending during the downturn, Vale is setting itself up to supply more iron ore when markets recover.
Vale is ready for an upswing
There's no guarantee that Vale's plans pan out as expected. However, it is positioning itself for continued demand growth in iron ore and an upturn in iron ore prices. That would be an upside double whammy. Iron ore is a cyclical industry in the midst of a downturn. If history is any guide, Vale is doing the right things to ensure it's ready for the eventual upturn.
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Reuben Brewer has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. 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.