Vale losing tight grip on Brazilian iron ore

The cliffhanger will it-won’t it of the giant miner Vale’s negotiations to take over Anglo-Swiss mining firm Xstrata has dominated Brazil’s financial headlines. The estimated $90 billion deal would realize Vale’s dream of becoming a truly diversified world mining leader. In its back yard, though, Vale is seeing new challengers emerge in its core iron ore market as prices head inexorably up. That competition is set to change the face of Brazil’s iron ore mining scene in the next few years as Vale loses its heavy dominance. Ironically, just as new Brazilian iron ore mines, and others round the world, come on-stream over the next few years, the price of the commodity is likely to sag.

The wave of new entrants will see Brazil return to a more fragmented market, repeating its history. Just 10 years ago, there were several mid-sized players. Since then, dominant Vale has snapped up a number of them, such as Caemi Mineração e Metalurgia for $426 million and S.A. Mineração Trinidade (SAMITRI). That wave of consolidation has seen CVRD reach some 90% of the domestic iron ore market, points out Marcelo Aguiar, mining analyst at Goldman Sachs in São Paulo.

That very high figure is likely to represent a peak of consolidation. High prices are prompting mine owners to dust off mothballed development plans, foreigners to buy Brazilian assets and smaller entrants to invest. This year alone, Vale has been able to push through 55% price increase following a 72% rise in 2005, points out Anita Saha, mining analyst at Fitch in New York. “These are unprecedented price increases, but we won’t go back to early levels,” she reasons.

CSN, MMX Look Big
For now, the two largest developers ex-Vale are steel maker CSN and the combination of MMX, part of flamboyant entrepreneur’s Eike Batista’s empire, and Anglo American.

The businesses of CSN and Vale have long been inter-twined thanks to a shared history. CSN bought close to 42% of Vale in an auction in 1997 before unwinding stock cross participation in 2001. The division of some spoils was not immediately clear and one prize CSN asset, Casa de Pedra in the central state of Minas Gerais, has been disputed between the two. Legal wrangling has held up the development of the site as Vale demanded first right to purchase any excess production not destined for CSN’s own steel mills. Since a court victory, CSN has been operating without sending details to Vale of those new projects which will generate more iron ore, says Aguiar. Having been defeated in this round.

Vale is now seeking legal redress for compensation. Meanwhile, CSN has been touting the mine to investors who have been enthused by the story and sense that CSN is winning the battle. “We’ve looked at Casa de Pedra and it’s a fantastic asset with very attractive expansion prospects over the next five years,” said one London-based fund manager, who was not deterred by the legal wrangle and sees CSN as emerging victorious. “Vale has been very dogged but the ball is in CSN’s court.” The company has said it is confident that it will be able to sell to third parties, he notes.

In 2005, production from Casa de Pedra reached 13.7 million tons of which 43% was sold to the market with the remainder used by CSN. The firm is now ramping up production, which will leap to approximately 65 million tons in 2012 from about 20 million tons last year, by investing some US$2.8 billion. It has said it aims to become the world's fourth largest iron ore producer. Iron ore sales will give in annual incremental EBITDA of about $1 billion in 2008 and 2009, notes Saha.

The tight supply of iron ore and high quality reserves in the Minas region are behind CSN’s significant investment, Saha says. CSN also has its own port to export ore and an interest in a train line to transport ore to the coast, a particular advantage given the logistics cost involved in using Brazil’s inadequate infrastructure. And CSN has excess capacity at the port that it can sell to third parties, says Aguiar.

CSN has been looking at spinning off the mining asset through an IPO that may be worth in the region of $5-7 billion. The deal is likely to meet high investor demand in spite of the choppy conditions prevailing on the Bovespa market, Aguiar says. Money raised could act as a useful currency for asset purchases either overseas or of other local mines and avoid excessive leverage.

The other major investor in the area is MMX, which has blazed a path in capital markets launching an IPO that raised R$1.12 billion last year. Then, in January, MMX signed an exclusive negotiation deal with Anglo American. If sealed, the $5.5 billion deal would see Anglo American gain a 63.6% shareholding in a new company which will be demerged from MMX and will own MMX’s current 51% interest in the Minas-Rio iron ore project and 70% interest in the Amapá iron ore project.

Eike Batista, the entrepreneur who runs EBX, the holding company that owns MMX, has said that by 2009 MMX will be the fourth largest mining company in the world and Anglo American says it could produce 150 metric tonnes per annum by 2017. Still, the cost of the deal for Anglo has raised eyebrows. “A couple of years ago it would have been hard to imagine anyone paying $225 in Enterprise value per tonne,” says Aguiar.

There are two likely reasons: either Anglo is predicting a much longer cycle of high prices for iron ore or it has confidence that the mine will produce much more than originally estimated, Aguiar reasons. Anglo American knew the project very well and must have known the risks, reasons Marcelo de Brisac, analyst in natural resources at Banco Itaú. That is borne out by recent upward estimate revisions of reserves. Others say that Anglo American has been desperate to gain a toe-hold in the key Brazilian market and was prepared to pay a premium to do so.

For Batista ,the $5.5 billion sale fits with his policy of buying cheap and selling high and does not mean he is out the market. He prefers to develop new projects rather than operate existing ones, too, notes de Brisac.

Indeed, MMX has already been buying mines in Minas Gerais. So far, these purchases have been on a modest scale. Last year, he bought two mines: AVG for $224 million and the much smaller Minerminas. AVG operates a single mine (Serra Azul) which produced 1.6 million tons in 2006, but Batista has already said that he will be able to lift production in his investments in Minas to 20 million tons by 2010. This will require investments of $300 million, he has announced.

Still, it’s probably just the beginning. Batista is looking for more mining assets in the area and is likely to sign a deal soon, reckons, Edmo Chagas, analyst at UBS Pactual. These will be significant Greenfield projects which will upgrade his portfolio in iron ore mining, he says. Batista is continuing to look at mining opportunities in the north (Bahia); far north (Amapá, Amazonas); and centre west (Minas Gerais, Goiás and Mato Grosso).

Smaller Projects
There are other smaller mining concerns that will further diminish the dominance of Vale. The largest of those is Usiminas which bought J. Mendes, Somisa Siderurgica Oeste de Minas and Global Mineração for $925 million on February 1, gaining annual production of five million tons. The steel firm has already announced that it will ramp up production to reach 29 million tonnes by 2013. Under the terms of the deal, the firm may make additional payments over the next two years depending on the quality and quantity of ore reserves.

Oslo-listed London Mining has a 100% interest in Minas Itatiaiuçiu, which is also located in Minas. It is ramping up production to over five million tonnes per annum from the area. MHAG Mineração has mines that are estimated to have 3.8 billion tons in reserves, mostly in northern Brazil.

The Global Picture
The big recent prices in the iron ore market are not just driving firms to open up new assets in Brazil; it is a global phenomenon, points out Aguiar. Firms in Australia, South Africa and Russia are all working to increase production as is India, although there government regulation complicates exports. Still, Brazil’s iron triangle in Minas Gerais is one of very few areas globally with undeveloped mines with good logistics, although ports continue to act as a constraint. Goldman rates Vale a buy with a 12-month target price of $53 per ADR and CSN a top buy with a 12-month ADR price target of $43.

For the next couple of years, iron ore prices are likely to rise, believes Aguiar. Each year the ferrous content of Chinese iron ore is decreasing. The iron-bearing rock in China is just 15-20% pure in China whereas much of CSN’s reserves have purity of more than 50% and Vale has reserves with up to 63% iron bearing rock. Steel demand is growing by 50 million tonnes per year in China and the gap between supply and demand will be very tight in the next couple of years, he says.

Goldman is forecasting that prices will go up by 20% in 2009. That should mark the end of the cycle with prices flat in 2010 and then decrease somewhat in 2011 as more projects come online and Chinese demand will have slowed somewhat. That will come at an awkward moment for those spending on new developments.

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