China has been the driving force of the steel industry for decades. It simultaneously produces and consumes about half of the world's steel according to the most recent figures from the World Steel Association. So whenever any change occurs in the way China manufactures steel, it is going to have a big impact on the market. 

One profound change that is happening right now in the Chinese steel market is in the type of raw materials it uses to make steel. That change in raw material selection could mean drastic changes to mining stocks. According to Cleveland-Cliffs (CLF 1.14%), it could benefit the company profoundly in the coming years. Here's what management is saying about the changes and what kind of impact they can have on the American iron ore miner. 

Iron ore mining.

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Not all iron ore is created equal

To most of us, the term "iron ore" is a pretty universal thing. To steel producers, though, "iron ore" can mean a lot of things. The primary variations on iron ore are known as fines, sinter feed, and pellets. Fines are the most common steel input, but they have the lowest iron content of the group and tend to be incredibly pollutive when used to make steel. On the opposite side of the coin is pellets, which are upgraded and partially processed iron ore beads that tend to be less pollutive and require much less energy to convert to steel.

For years, Chinese mills have used fines with lower iron ore content because they were the cheapest option. However, recent efforts to curb pollution have led to many steel mills electing to use pellets. On Cleveland-Cliffs' quarterly conference call, CEO Lourenco Goncalves noted that demand for iron ore pellets in China is having a profound impact on the price of these higher-grade inputs. He also pointed out that manufacturing pellets takes a lot of time and money. 

China is now very hungry for high iron content iron units, particularly pellets, and that is happening in a world where pellets are scarce.

The difficult expense, lengths of time and proper conditions needed to bring pellets capacity online gives us the confidence that this is not a short-term phenomenon. You need a certain type of iron ore, a substantial amount of freshwater, like we have here in the Great Lakes, a lot of funding, time and technical knowledge. This is not de-bottlenecking logistics to bring another 20 million or 30 million tons of commercial quality ore to the market. A brand-new pellet plant needs billions of dollars over several years to add just 5 million or 6 million tons of pellets to the market. And on top of that, no major realistic project has even been announced yet, let alone developed.

With this as a backdrop, the Chinese paid almost $90 per metric ton for the pellet premium during the third quarter. The Atlantic basin pellet premium, the index that our contract's linked to, has held steady since the beginning of the year at $58 per metric ton as the European contracts are typically negotiated on an annual basis.

This trend isn't something that has happened overnight, either. According to Bloomberg, Indian iron ore pellet producers have increased their exports to China by 13-fold from 2015/2016 to 2017/2018, and pellet prices in China are now more than $150 per ton even though the current price for standard 62%-iron-content fines is $75 per ton. 

Perhaps it was a data point that analysts missed, because Goncalves stole the spotlight with some less-than-complimentary comments about short-sellers and analysts, but high global pellet prices can mean a lot of money to Cleveland-Cliffs' bottom line because of the way it structures its contracts with buyers. The contracts it typically signs with customers are for prices linked to the Atlantic Basin pellet premium, which is the price most steel mills in the U.S. and Europe pay for pellets. With global iron ore prices rising so fast, management expects that the next round of contract negotiations will result in a much higher premium for pellets, and Cliffs seems to think it will lead to a large uptick in profitability in 2019. Here's Goncalves again:

At this time, it is abundantly clear that the major pellet players in Europe will not accept $58 for next year. They will certainly push that number higher, maybe much higher. As far as Cliffs is concerned, even an increase to just $70 for next year in the pellet premium would equate to more than $100 million in additional EBITDA for us, all things equal.

Just for reference, Cleveland-Cliffs has generated $676 million in EBITDA over the past 12 months, so a $100 million boost is a big needle move for the company. 

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It's not just about tariffs and trade

Much of investor sentiment for steel in the United States centers around U.S.-China trade relations and tariffs on steel. While it is certainly playing its part in boosting steel prices and demand for both steel and Cleveland-Cliffs' iron ore, it isn't the sole factor that investors should consider when looking at this mining stock. The way steel is produced globally is moving toward using higher-quality and upgraded raw materials, and that benefits Cleveland-Cliffs immensely when it comes to pricing of its product.

Even though there are some clear tailwinds for the company, it has done a spectacular job of turning around its finances in a relatively short amount of time, and it has reinstated a dividend; its stock trades for a ridiculously low price-to-earnings ratio of 3.7 (no, that's not a typo). Investors looking for a great stock trading for an incredibly compelling valuation should look hard at Cleveland-Cliffs today.