As Xi Jinping drags China kicking and screaming back to the good old days of pure communism (with Chinese characteristics), huge chunks of the economy are being ripped apart and buried.
Whether it be Chinese private tutoring companies, boy bands, makeup artists, influencers, actresses, or even Jack Ma’s Alibaba, nothing is sacred.
There’s nothing unique about what China is doing — other world leaders are also deliberately wrecking their economies in a global power grab for authoritarianism.
What is unique about China, though, is that it is the world’s largest supplier and consumer of steel, by a mile:
Right now, we think China’s production is going to implode. That means iron ore prices are going to tumble. Two determinants of iron ore demand are steel manufacturing and relative costs for mini mills vs steel furnaces.
The two main ingredients that steel furnaces need are coking coal and iron ore.
Coal prices are soaring
Coking coal usually trades ate a premium to thermal coal because it’s high quality black coal.
However, the shortage of thermal coal has sent prices soaring to well over the 10 year average coking coal price.
This means, quite simply, that the cost of making steel from iron ore is going to be prohibitive. The only mills that will be able to make money in this environment will be mini mills that recycle scrap steel — a significantly less energy intensive operation.
Xi just drove demand off a cliff
One of the main drivers of the Chinese economy has been construction. China is in a strange situation where people have more money than they can find investments for, so they invest it in real estate. For a while, this was going overseas and large groups of Chinese investors were herded from country to country to be separated from their money. After that window closed (and even while it was open) this demand for investments created a massive demand for housing.
This is almost unique in the real estate world where apartment buildings were built solely to satisfy investment demand.
Very few people moved in, which is why China ended up with thousands of ghost cities.
If you haven’t seen a video of them, it’s worth taking the time to check one out.
The reason we’re talking construction is that this is half of China’s steel demand.
The biggest story from China this month is that China’s largest (and most trusted) real estate developer, Evergrande, is collapsing. Previous Chinese leaders would never have allowed this. However, Xi isn’t like other leaders. He cares less.
It’s managing to avert official bankruptcy by defaulting only on people who don’t matter (Chinese retail investors) and offering them discounts on future construction projects instead of cash.
If the projects look anything like what you see in the video, then you know they aren’t worth a thing and probably wont’ get built.
Second hand housing prices have been falling since 2017 in Shanghai — a tier 1 city. For development going on in the rest of the country, prices are going to be even more dire.
Now that Chinese are getting wise to the housing scam, they are no longer buying. Some real estate agents report that the number of buyers in the market has dropped by 90%.
This is dire and the consequences will be very very real: Construction will grind to a halt.
Given that China is also around half of global demand, that means global demand for steel is going to fall by 15-20%. Moreover, as the apartments collapse or are torn down for scrap, and suppliers try to dump their unwanted inventory of rebar, steel scrap prices are going to tank, making mini-mills the only economic producers of steel.
Korea’s POSCO, the most efficient smelter in the world, will be able to continue due to long term contracts for coking coal. China’s steel companies won’t.
Vale is the most exposed iron ore supplier and is going to tank
The largest iron ore companies are UK’s Rio Tinto, Australia’s BHP and Brazil’s Vale.
Right now, Vale is trading at 12.50, well below it’s year high, but a multiple of where it will be when iron ore prices tank.
Two thirds of Vale’s revenue comes from iron ore, of which over half goes to China.
Interestingly, even as the iron ore market is about to implode, Vale is expanding:
This is a very bad time to be expanding and the company will be punished by the market and with significant losses. Iron ore prices are already falling.
Many people would look at this chart and think, “They must be at bottom already.” They would be wrong.
The standard 62% ore dropped to $50 back in 2015 and 2016 and we’re probably heading back there right now.
Industry commentators have forecast low prices for 2023-2025, however they seem to be a bit rosy for 2022 in our opinion, given current sport price is $93.63 per ton.
The problem for Vale is that it’s in South America. That’s a long way from China. Shipping iron ore now costs around $22 a ton (compared to $10 from Australia) so Vale doesn’t have much of a cushion.
Specifically, back in 4Q2019 when prices were similar to today ($88.6), their COGS for ferrous materials was $3,763 million for revenue of $6,451 million. So gross profit was 42% and costs were $51.68 per ton. For the most recent quarter, the company reduced costs to $46.73 per ton (costs vary significantly depending on which ore is mined).
Can the company drop costs further? Sure. Mining companies typically mine the highest cost (or lowest value) ore during high price periods and mine the lower cost ore during low price periods.
However, there’s a pretty significant limit to how far a company can drop prices and how long they can sustain mining low cost ore.
Quite simply, the company will be forced to close some of its mines.
This long slump will be very very long. The Fitch forecast above is, in our view, rather rosy.
Even at $70, Vale will be struggling to make any money at all. Once prices fall to $60, gross profit will be negligible. As Vale’s iron ore has high water content (Australia’s is bone dry) it sells for $5-12 less than the standard dry price.
The company has enough cash to survive the next few years, but it won’t be generating enough free cash flow to justify a $61 billion valuation.
Rather, we expect it to be valued at 1x revenue, which would be less than $40 billion. That’s a one third price fall from here with a target of $8.35, which is where it was in April last year. It should really fall a LOT further than that to its 2016 low of $2.13, but money printing by the Fed means valuations are going to be permanently higher.
How to double your money as Vale falls to $8.35
Vale stock options are thinly traded, so you won’t get a good price on long term put options. However, the January 2023 calls have decent trading volume, so the market makers will come to the part on that side.
The way to play this will therefore be by selling a long term put option spread. Specifically, I recommend selling a 10/12 call option spread expiring on January 20, 2023. This consists of SELLING the $10 call and BUYING the $12 call. The Yahoo Finance numbers are VALE230120C00010000 and VALE230120C00012000.
You should be able to open this spread for $1.10 ($110 per contract) or $3,300 for a 30-contract position. Remember, you are SELLING TO OPEN a vertical call spread, not buying it.
The risk for selling this spread is $2. However, you’ll be bringing in $1.10, so the real risk you are taking is the remaining 90c.
If Vale’s share price does indeed collapse, then either we’ll close the position out at a profit, or else wait let the options expire worthless for a profit of $1.1, or 122% on the 90c you risk.
Current open positions up $5k
As of Friday’s close, our two open positions were up a tad over 50%.
Happy investing.
P.
Update November 16: Position opened at 1.19
You should have been able to open the position at 1.19 ($119 per contract) or $3,570 for a 30-contract position. The options traded at 1.86 and 3.05 in medium volume. That money will be in your bank account and if vale goes as we expect then it will be nearly all profit.
