Vale: EU Steel Production Cratering Is Counter-Intuitively A Positive

Investment thesis: There are growing signs that the European steel industry can potentially collapse, becoming just a shell of itself. Vale (NYSE:VALE) is shielded from the problems facing companies that have business ties exposure to the European energy crisis, which is compounded by increasingly draconian environmental policies that make it hard for energy-intensive companies to operate. At the moment the EU steel industry, as well as many other industries are kept afloat by hundreds of billions of euros in aid & subsidies, which is not sustainable in the long term. The assumed collapse in EU steel production is a positive factor for those miners supplying the steel companies, such as Vale that are not directly exposed to the difficulties that the European-based steel production facilities are faced with. On the back of assumed higher global steel prices, Vale stock is likely to see more long-term price appreciation, while the very generous dividend is less likely to be cut.

The latest financial results are good, but a few challenging quarters may lie ahead, due to global recessionary pressures.

For the latest quarter that Vale reported, it recorded net operating revenues of just under $10 billion. It is a significant drop compared with the same quarter in 2021 when it had net revenues of $12.3 billion. Net income came in at $4.46 billion, which is a healthy profit margin of nearly 45%.

As far as volume sales of minerals and the realized price, there are some positive highlights, as well as some more negative trends.

As we can see, Iron ore realized prices declined somewhat in the past year, which accounts to a great extent for the significant decline in revenue that we have seen. A few more months of hardship in this regard might be expected, most likely until China’s industry will recover from the effects of the Zero COVID policy, and the immediate after-effects of opening up, which is leading to a huge wave of infections.

The positive that I see in the data has more to do with some of the byproducts, such as silver and cobalt, which are minerals we increasingly see used in green and high-tech industries. We are probably looking at a separation of its core iron business from its secondary byproduct part of the business as it has been recently highlighted here on SA recently by author Bram de Haas. We will have to wait and see how it will shake out before we can get a clear picture of the net impact on Vale and on investors. It may end up being the case, that regardless of the global economic weakness that we may see in the next few quarters, Vale stock might be more affected by the ongoing process of the company’s reorganization.

Vale’s stock price prospects remain decent as long as the duration of the global economic slowdown will be short in duration, with signs of recovery later this year.

Steel prices have been trending downwards, mostly on the back of a slowing global economy, as well as a less than upbeat outlook for the immediate future, which we assume to have a negative net effect on global steel demand.

Even though the price of steel rebar has been trending down, it should be noted that it is still trading at a price that is comparably slightly higher when compared with the average price we have seen in the decade from 2010 to 2019. This is an important fact that needs to be highlighted, given that we are in the midst of a slow global economic growth patch, with expectations being for the economy to continue to decelerate this year compared with last year, based on the latest IMF forecasts. The fact that we are not seeing a plunge in steel prices, or in iron ore prices that tend to trade in a positively correlated fashion, but rather a retracement back toward the average seen in the last decade, suggests to me that we are set to see iron prices far above the past decade’s average once we supposedly move into a new cycle of global economic expansion.

A very significant factor that may help to keep global iron & steel prices higher for the foreseeable future might be the long-term contraction of Europe’s steel output, which seems to have accelerated since the energy crisis began in the fall of 2021.

As we can see, EU monthly steel production is close to lows seen this century during the 2008 financial crisis, and the COVID shutdowns of 2020. My guess is that at some point this year or next year at the latest, EU steel production will see levels below those previous lows, and this time, there will be hardly any rebound as EU energy prices are likely to stay elevated for the foreseeable future, with the added risk of outright shortfalls increasingly dependent on weather factors.

At the moment, government spending amounting to hundreds of billions of euros meant to soften the economic blow is masking some of the damage to the EU economy and energy-intensive industries, but I foresee an end to such practices will occur soon, because such high levels of spending are not sustainable as a long-term solution. The EU economy will at some point have to structurally readjust to the new reality, post-divorce from cheap Russian energy supplies, and it will inevitably amount to a massive dive in energy-intensive industrial activities. Steel demand will probably decline significantly, but I expect production to decline even more, possibly nearing a complete wipe-out this decade.

For companies like Vale, the difficulties that the EU steel industry is facing have to be seen as a net positive. One of the biggest threats to investors at this point is the possibility of seeing the very generous dividend, currently in the 8.3% range slashed. Steel prices should remain high for the foreseeable future, given the loss of European supplies, which should translate into higher iron ore prices, given that the two tend to move in tandem.

This may seem counterintuitive, given that lower EU steel demand and production will translate into lower iron ore demand. In reality, this is not a zero-sum game. As a steady decline in EU steel production is a part of a wider trend of European industrial activities being replaced by activities based in other regions.

As we can see, for much of the past decade, EU exports went into a constant declining pattern, while imports have been steadily growing, with the EU establishing itself as a net importer of steel, meaning that capacity is being utilized elsewhere, even as it is shattered in Europe. The net result is supportive for the global steel market price, given that overall steel production capacity is experiencing some constraint. Higher steel prices tend to drag iron ore prices along higher as well. It is just one of those things where one would expect to see the opposite effect. In other words, even though a decline in EU steel production has a very temporary and increasingly small net negative effect on global iron ore demand, the negative effect on the price is more than offset by the positive price effect of growing net demand of steel imports by the EU, from other regions.

While Europe is now clearly headed down the path of deindustrialization, the world overall is still in net industrial expansion territory, which will require continued growth in iron ore supplies, as well as the increasingly important secondary resources that Vale is marketing. With more and more economic activity migrating to the developing world, the intensity of crucial commodities intake in the global economy tends to increase per unit of global GDP growth, because the developing world needs far more infrastructural development than the already saturated developed world. Vale is well-positioned to take advantage of it from a geographical point of view, as well as from the point of view of being a miner that provides the products that the global economy increasingly needs for the long-term.