Ore and More

Shagang seeks to buy stake in CSN’s iron ore unit

Benjamin S. is always willing to sell his good assets to protect his not-so-good ones. CSN controlled Vale, and when the split came, Benjamin S. went the steel route. The fact is, he probably did not have a choice at the time, but had he instead even taken a minority stake in Vale, he would have been better off.

Now he has put a mine up for sale. The reason for this is simple. Greenfield steel mills cost $2,000 per tonne of annual capacity to build, and he wants to double his steelmaking capacity. The only way to do this is to get a balance sheet that can spend the cash, and the asset to sell to get that balance sheet is the mine. As a 10 million tonnes per year steel producer, he is going to need 16 mt/y of iron ore. The rest of the ore is going to go to the seaborne market, and he is betting that he can get more in a lump sum now in this bull market than he could get over the life of the mine in earnings.

So he has a 2/3 interest in a 45 mt/y mine to sell, and the questions are, what is the value of that and who are the buyers?

Let’s start with the potential buyers, both miners and steel companies.

First, the miners: Xstrata, Anglo American, BHP, Rio Tinto, Teck Cominco, and Vedanta. Now, who on this list has the guts to make this kind of purchase? I think Xstrata will make a real bid. They need the asset, and they will pay dearly for it. It would really help Anglo’s iron ore strategy, so they will make a real bid. It is a good project to sit alongside the MMX project. It would, on top of what they own, put them in shooting distance of 100 mt/y of production. BHP and Rio Tinto will both make a real bid as it will further their Atlantic basin relationships, and they both need that. They also have the strongest balance sheets in the business. I think this project is going to be too rich in price for Teck or Vedanta.

The steel company buyers are going to be a different list: Baosteel, Sinosteel, Minmetals, and the rest of the Chinese will put in bids. Arcelor Mittal will put in a bid. He, however, likes to buy distressed assets, and not ones that can command full market price. I expect 2-3 Russian groups will put in bids—Severstal, for example. I do not see Tata putting in a bid as this would stretch their balance sheet, but then again, those that take the risks get the reward.

How the deal is going to be priced is very simple.

We can assume that the expansion is going to cost $80-120 per tonne of annual capacity. I am going to work with a 40 mt/y mine, but you could probably goose the project up to a 45 mt/y mine. There is currently a 14 mt/y mine. I am going to assume that CSN wants to keep 16 mt of production. So they are selling a 24 mt/y mine.

The operating costs of this mine will be under $20 per tonne, but we are going to say $20 to be safe. The product is an excellent concentrate, and will fetch full fines price. It is a really attractive product to China as they can use it to blend with domestic ores so that they can produce decent pellets. Current fines price is $1.22 per MTU of iron ore, and assuming a grade of 66%, the value of the ore is roughly $80 per tonne. So we have $60 in margin. I am going to assume a 10% discount rate, no growth in the price of iron ore, and a 30% tax rate. With these variables, I get a simple enterprise valuation of $420 per tonne of annual production (60*.7)/.1. Now, we are going to have to subtract the $120 per tonne of capital expenditure because we still have to pay for that, and I end up with a valuation of $300 per tonne of annual production. With 24 mt of production to be sold, he should get 7.2 billion USD.

I think that is the floor of the valuation, I would not be surprised if he got up to 10 billion USD for the mine, as I think there is some growth in capacity beyond my numbers. In any case, this is a significant amount of capital, and it should let him double the size of his steel works debt-free.

On the whole, if I were in Benjamin S.’s shoes, I would sell the mine under those terms as the thought of taking $10 billion of leverage and keeping the mine is very scary. If I were Mittal, I would not sell the mine, but rather use the supply of cheap ore as a method to buy other steel companies. Benjamin S. has proven, however, that he does not have the nerve to buy when the assets are cheap, so he is right to sell when he can get a decent price.

The new barrier to entry is the environmental license to operate. Okay, that seems like a simple statement, but whenever I look at industries that interest me–and I do not mean mines, but actual factories–the single largest barrier to entry seems to be the license to build the plant. This, coupled with at “not in my backyard” (NIMBY) attitude toward many factories, is resulting in some serious, unintended, and largely ignored environmental consequences.

“Not in my backyard,” said one little hen to another of a new steel mill. “Well, we must make the steel in China and import it then,” replied the second little hen. The first little hen can drive off in her Toyota Prius and feel like she has won a major battle, but she hasn’t really. In her backyard, the factory would have been built to stringent Western environmental impact standards. In China, the factory will be built to no standards.

Now, this transplanting of factories will not happen in some cases. Whether it does or not wholly depends on the weight-to-value ratio of the goods being produced. Gravel, for example, is very hard to ship, It has a value of around $10 per tonne, or $20-30 per cubic meter. It is not going to travel very far without the freight costs ending up eating the margins on the product. On the other extreme, finished computer products, which have values in the $10 million per cubic meter, will go anywhere there is money to buy them.

So a corollary emerges from the convergence of NIMBY attitudes, the environmental license barrier to entry, and weight-to-value ratios. If a product has a good value-to-weight/density ratio, it can be made anywhere and then will move to the land of the highest selling price because the freight costs less than getting the environmental license. If a product has a low value-to-weight/density ratio, it might still move, but it won’t go far because the freight costs will more quickly outweigh the cost of the local permit.

An interesting conundrum thus develops when the NIMBY attitude and environmental license barrier to entry are paired: this pairing won’t move out all factories, and the factories that do move may cause far more damage in their new location than they would have in the West.

Steel is a “not in my backyard” sort of product. It, however, can travel. An oversupply anywhere in the world will quickly travel to the backyard of the people who do not make it. Even if, for example, it is impossible to get a permit for a new blast furnace in the UK, one can be built in India. The product from that one in India, if it cannot be sold in India, will wash around the world as quickly as it legally can. This ease of travel is, in fact, the steel market’s weakest link. A 3% oversupply in China will result in a global meltdown of steel prices.

The funny thing is, for a NIMBY product like steel, the third world is only too happy to make lots of plants to make it, knowing they can sell it wherever they like if they make too much. And in making these lots of plants to no standards, they are doing lots of harm. So all of you environmentalists, next time you boycott that oil refinery in the United States, remember you are just going to support a new one in India, one that, I can assure you, will do much, much more environmental damage.

It has been a long week and I have been traveling a lot, so sorry about the scarcity of updates. I have spent most of the week thinking about why I like to own mining assets and not steel mills.

When I started in this business, I read every history I could get my hands on, and because of the unique perspectives of recent histories, I rather liked reading dated books. What was really interesting was reading about U.S. Steel from a 1910 or 1920 perspective. From the perspective of writers at this time, U.S. Steel could make no mistakes—well, they were ruthless—but they were going to be the golden boys forever.

By 2000 or so, U.S. Steel had the same market cap that they had at the time of their IPO. After 100 years of being a huge company, their total value was the same as it had been when they began: in absolute dollar terms, around 2.5 billion USD. Now, of course, in 2008, the valuation is massively up, but it still is probably less than the replacement cost of their plants.

Now we are on to another expansion boom and I am asking myself the question, what will be different? Will demand stay beyond the ability of China, India, and everyone else to add capacity? There is no barrier to building a steel mill beyond having land, water, and a bank account. Of course, it helps to build one where you have open water to bring ore and coal in cheap and ship out the steel, but people have made mills work without even that asset.

Over the next 20 years, (macro time, I know) steel is going to be a zero-sum game. The only saving grace is the iron ore oligopoly might have the common sense to cut back ore supplies if the market gets weak.

I can promise you that some highly leveraged steel companies, when faced with making their bond payments, will cut prices and cut prices to sell that last tonne of production.

I think the way to make money is to buy mills or shares of mills cheap and sell them dear, but unless you are Mittal with his iron touch, this is a hard business.

Australia’s richest man, woman in iron ore mine fight

In case you get bored, there is a new fight in town that might give Ultimate Fighting a run for its money. It is Rio and Gina against Twiggy and Cazaly Resources Ltd. This is a fight that BHP could have paid for. If it is credible (doubtful), it will really help BHP on its takeover of Rio Tinto. From my perspective, this is just a good chance to grab some popcorn and catch an exciting show.

Reuters: Indian government revises duties on iron ore, steel

India has hiked its export duties on iron ore, and it is not a bad thing. It will give the government some money. I do not really see it impacting the margins of the Indian iron ore companies as they will just pass it on to the Chinese. I also do not see it really helping the domestic market that much as it will just give a fairly small advantage to selling domestically. I expect the total margin impact for a Indian steelmaker to be under $25 per tonne savings if they were buying 100% on the spot market.

This, in my mind, was expected and was a non-news event.

Benjamin

Sea Piracy’s Bloody Growth

As shipping gets more valuable, more people feel that they can take by gun what they cannot afford by SWIFT. Having said that, at least they probably are not trying to take iron ore carriers or other bulk carriers as it is very hard to run with iron strapped to your speed boat.

NMDC may hike long-term iron ore contract prices

The Indian state government, which has traditionally discounted ore to its domestic buyers, is now going to be selling it at full market price. At least, however, they are not going to be selling it for the spot price. Price controls are funny things. They can work in places like China, where the government has the reserves to support them, but in other places they tend to distort the market. In India they have significantly increased the price of ore by keeping supply down by slowing development.

How much iron ore is there is India is the real question at hand. POSCO and Mittal are fighting for what should be easy tonnage, and the government cannot deliver them the leases in sufficient quantities for the 25 million tonnes of steel production they want to install. I have to be missing something as everyone says there is loads of iron ore in India, but maybe it is all in national parks, or just tied up in a nice red tape ball for the world to look at but never touch.

Good job, AXI guys. This is an incredible amount of work.

http://www.newswire.ca/en/releases/archive/June2008/13/c3700.html