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What's Brewing Between China, Vale, and the Baltic Dry Index
by: Hard Assets Investor posted on: September 29, 2008 | about stocks: RIO / SEA

By Julian Murdoch

There's an interesting story playing out between China and Brazil. It's about iron and steel and ships, and it could have a bigger impact than you think.

In early September, Companhia Vale do Rio Doce (RIO) announced that it wasn't happy with the 65% price increase it negotiated back in spring with China for its iron ore contracts for the year that started in April. Vale negotiated separate price increases for its European and Chinese customers, and apparently, they're regretting that.

One would think that once the negotiations are concluded and the contract signed, that would be that. At least, that's how things usually work for me. But as any lawyer would tell you, you can always try to renegotiate. That's what Vale is working on.

Here's the logic: At the time of the original deal, when the then unheard-of increases in the price of iron ore were negotiated, steel makers knew a price increase was coming. Supply was low, demand was high and the iron ore companies were facing increasing costs as energy prices skyrocketed. The steelmakers weren't happy, but they understood the score. They went into the negotiations knowing they were facing a price hike - it was just a matter of keeping it to something they could afford.

The steelmakers themselves were also facing increasing energy costs and had to account for increasing transportation costs as shipping costs rose due to high fuel prices. Demand was high for dry bulk ships, and Chinese companies were stuck paying the high rates because they needed the iron ore (and coal, and the other commodities that travel on those slow boats to China). Apparently the Chinese steel makers were able to negotiate a slightly lower price for their iron ore by crying poor - they had to pay higher shipping prices to get the ore from Brazil to China.

Well, since then, the bottom has dropped out of the shipping market, and Vale wants a mulligan.

Vale is asking for a price hike of around 11% in order to bring the price of iron ore shipped to China in line with ore that's sold to Europe, on the idea that shipping costs have come down, which they have. When I wrote about the Baltic Dry Index a few weeks ago, it was down 50% from its early summer high. Make that 67% today.

Chart: Baltic Dry Index performance June '08 to Sept. '08

Last week alone, the index dropped 25% due to global economic worries (shipbuilding takes credit) as well as this little tussle between Vale and China. Perhaps the long-horizon shipping collapse analysts have been predicting (which we wrote about before) has arrived quicker than anticipated. Or maybe this is an opportunity to get in the Claymore/Delta Global Shipping Index ETF (SEA) near the bottom.

Since this all began, China has accused Vale of slowing down the loading of iron ore bound for China, tying up ships and reducing China's iron ore imports in an attempt to pressure China to accept the price increase. Vale has, of course, denied both the Chinese allegation and a report by Lloyd's List claiming the same thing. (Color me skeptical, but the classic Teamster-slowdown tactic has been around since Sumerian slaves weren't happy with the gruel.)

Roger Agnelli, CEO of Vale, spoke Friday at a sustainability forum hosted by the company. Here are few of the relevant sound bites (courtesy SmartMoney):
There has been no cut in shipments. We have zero tons of iron ore at our ports.

Despite the grammatical challenge presented here, isn't this a contradiction? Is Agnelli saying that they are shipping everything that is coming out of the ground in an attempt to prove that Vale has not cut shipments? Or is he stating that Vale has not cut shipments in the past, but that may not be true in the future because Vale has no inventory to ship? If it is the latter, we might want to cast a skeptical eye on Vale's forward earnings.

In defense of the price increase, Agnelli said:
In practice there will be no rise for the Chinese because the fall in freight prices will compensate them. Shippers are strongly arbitrating freight prices. China is shouting and crying but is losing nothing.

Then there is this beauty:
If Vale stopped selling ore to China, then the Chinese steel industry would stop.

Talk about biting the hand that feeds you! This is Chicago-level hardball. Vale's main iron customer is China, and we all know that China demand is driving steel growth.

But does China need the ore right this second? Perhaps not. Prior to the Olympics, China stockpiled all sorts of materials. Imports of iron ore for the first eight months of this year were 23% higher than for the year prior. With many steel mills closed during the Olympics due either to energy restrictions or pollution control, that ore didn't get used. On September 18, vice chairman of the China Iron and Steel Association Luo Bingshen said that there were 80 million metric tons of ore in Chinese ports. More recently, the association reported demand growth for steel products is slowing - growing only 6% last month, as opposed to the 13% growth seen the year prior. Blame it on rough times in the global economy and decreased auto sales.
Chinese steelmakers ‘have shown no interest' in reopening plants because of ‘languid' demand from customers such as carmakers and builders, Bank of America Corp. analysts Michael Pak and James Lee said in a Sept. 22 report. Demand from China may also be hindered by National Day holidays that run for a week from Sept. 29. [Bloomberg]

What does this all mean for Vale?

Vale's stock price is down 52% from the high it hit on May 16, and down 38% YTD.

Chart: NYSE: RIO performance, Sept '07 to Aug '08

Of course, with everything going on in the markets right now, we can't say that this decline is in any way because of the China negotiations - a lot of companies have similar landslide-of-shame charts.

With its third-quarter report due out on October 23, we will need to wait and see how the company has fared during this renegotiation and what the market thinks it is worth.

If China can get the ore it needs from local mines and other suppliers as it has threatened to do, and continues to resist Vale's pressure, negotiations for next year's contract which begin in November will be interesting, to say the least.


This article has 4 comments:

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Chris B
Sep 29 02:24 PM
The link to a discussion of falling shipping rates was the most useful thing to me.

Anyone think Vale is trying to pressure the Chinese into buying them? Report abuse
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John Egan
Sep 29 05:11 PM
Chris B... Interesting question... It has been rumored frequently that RIO, PCU and AA are all on the Chinese 'buy' list... Shame I keep getting stopped out of each of these..

Vale has a lot going for it... In particular, they have their own land transportation system in place... And, they have ordered their own small fleet of transport ships. It would seem they are trying to circumvent the 'cost of transportation' issue. Admittedly, the ship order could be cancelled if the economy keeps tanking...

After today, I'm wondering if I might be able to get some of these fine companies for under $10 a share... ??? OK... Just joking... I hope!

jegan Report abuse
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Socialism
cannot
compete!
Sep 30 02:14 PM
No way Vale gets bought by China...Brazil is making all the right moves with its key infrastructure players right now -- RIO and PBR are both critical cogs in the government's plan for economic prosperity several generations down the road. They will not let it happen. Report abuse
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BlueDog
Sep 30 07:17 PM
My Website
Nice synopsis of the situation. It would have been nice to have heard your thoughts on probable outcome.

http://seekingalpha.com/article/97840-what-s-brewing-between-china-vale-and-the-baltic-dry-index?source=yahoo