Geordie Mark: Global demand for iron ore on rise

How long until the window on rising iron-ore prices closes? Global demand is driving prices higher and shipping costs are at historic lows. But only companies poised to get into production quickly will be able to capitalize. In this exclusive interview with The Gold Report, Geordie Mark, an analyst with Haywood Securities in Vancouver, picks the companies that are ready to profit and those that are likely to get picked off by competitors.

The Gold Report: BHP Billiton Ltd. (NYSE:BHP; OTCPK:BHPLF), one of the world’s largest suppliers of iron ore, recently submitted an environmental review for a proposed $48 billion expansion of the Port Headland Harbor in Western Australia to accommodate the doubling of iron ore production from its Pilbara operation. When a company’s willing to spend $48 billion at one operation, what does that tell us about the long-term fundamentals about the iron ore business and, ultimately, the steel business?

Geordie Mark: The thesis there is one of global growth in steel demand resulting from continued industrialization from advancing economies, particularly China. At the moment, China produces somewhere near 45% of the world’s steel.

On the back of that, India is continuing to grow its internal steel production at greater than world average rates. So, 37% of the world’s population, which includes only China and India, has significant growth in its underlying steel consumption and demand.

If you take a step back, these countries are both in the juvenile stages of their steel use. They still have a long way to go in ramping up their countrywide infrastructure requirements. This trend is expected to continue for a number of years, if not decades.

TGR: Investors commonly think of China and India as the primary drivers behind steel demand. However, I have a November 2010 report from UBS, which estimates that steel consumption this year will rise by 4.5% in Europe, 4.5% in Russia and 5% in Brazil—a little bit more than India and China. The growth forecast gets even more bullish in 2012. Are Haywood’s numbers similarly robust in countries outside of China and India?

GM: I would have to agree. China is obviously the main source of growth due to its size. For example, China’s steel consumption is roughly eight times that of the U.S. But we are seeing significant growth from other countries, too. There are significant growth projections coming out of Europe, Russia and Brazil. The World Steel Association estimates global growth this year at 5.9% and 6% for 2012.

TGR: All that competition for iron ore is driving up the cost. China’s imports of iron ore in the first quarter rose almost 15% to about 177 million tons (Mt). Meanwhile, the average import price was $156.50/ton in the first quarter, about 60% higher than in the year-early period. What are some ways to play this remarkable growth?

GM: To play the growth, investors could look to companies that are either entering into production or can enter production in this period of high prices, which we believe will be about five years. In the short term that could include companies entering into production this year in order to get near-term cash flow and strong margins. An example is Labrador Iron Mines (TSX:LIM). We expect Labrador to start production within about a month’s time from a direct-shipping style operation.

Investors could also find growth in development-stage companies that could go into production within the window of high prices. For example, Northland Resources S.A. (TSX:NAU) has a project it anticipates it will start mining in late 2012 for high-quality iron ore concentrate product.

TGR: What’s your prediction for prices a year out from now?

GM: This year we are forecasting an average price of around $139.50/ton for 62% Fe iron ore FOB Brazil. Next year, we forecast about $124/ton.

TGR: Why are the prices going down?

GM: We have taken a conservative approach to building our forward commodity price curve given known supply growth, as well as uncertainty surrounding seaborne transport rates. Furthermore, concordantly, the commodity has witnessed elevated pricing volatility whereby about a year ago, the industry came off an annual benchmark approach where the Big Three, that’s Vale S.A. (NYSE:VALE), Rio Tinto (NYSE:RIO; ASX:RIO) and BHP, negotiated with steel producers on an annual basis to fix prices. The rotation of the mechanics of commodity pricing within this industry was a result of the underlying demand-driven environment, which now places the iron ore producers with a lot more say in negotiations.

World iron ore pricing rotated out of an annual benchmark into quarterly indexing and a greater reliance on the spot price markets. In the last first quarter and second quarter price negotiations, we have increases in prices for the Big Three, but as stated earlier we will also see greater volatility in the spot market relating to seasonal events and any fundamental policy changes out of China and other growth steel producers. Since we do see greater potential for volatility in the market going forward, we’re resting on the conservative side for pricing.

TGR: The value of companies with iron ore assets or projects increased by an average of 400% between October 2005 and October 2010, whereas the value of metallurgical coal companies increased 34% during that same time, according to the UBS report. Steel companies were up 12% during that period. Part of that value creation is because steel companies have gone upstream and bought iron ore juniors to control the cost of supply. Do you expect that trend to continue?

GM: I would say the valuation metrics driving steel companies and companies with iron ore assets differ appreciably given that the steel companies work on operating margins and output growth, whereas companies with iron ore assets and projects have moved up because they’re increasing the underlying resource base, lowering apparent risk by moving through development or entering production in a market with elevated commodity prices.

We do see vertical integration being a very significant component going forward for the steel producers. Steel producers want to hedge away from the Big Three. These companies want to be independent and integrate their cost management into locking up some of their iron ore at cost. Such integration enables steel companies to be more competitive when selling steel. We believe that there is likely to be continued vertical integration in the sector as steel producers lockup supply and protect the underlying cost base.

TGR: One example of that was when Cliffs Natural Resources Inc. (NYSE:CLF) bought Consolidated Thompson Iron Mines Ltd. (TSX:CLM)

GM: That’s exactly right. Cliffs and Consolidated Thompson have a lot of operational synergies in the Labrador Trough. Cliffs was able to pay a good price for Consolidated Thompson. The Canadian operations had operational synergies, so that arrangement worked for Cliffs.

Another example of vertical integration would be Tata Steel Ltd. (LSE:TTST; Grey Market:TATLY) forming a joint venture with New New Millennium Capital Corp. (TSX.V:NML) on a direct-shipping ore project in the Schefferville-Labrador Trough, as well as participating in a bankable feasibility study on New Millennium’s large taconite deposits near Schefferville.

There is good vertical integration potential in the sector, particularly within areas that have existing infrastructure or reasonable assurance in terms of asset ownership. Canada is a very good home for such activity.

TGR: You recently revised your price target on Alderon Resource Corp. (TSX.V:ADV; OTCQX:ALDFF) from $3.90 to $5.80 after it published a resource estimate on its Kami iron ore project in Labrador. Was it the size of the estimate that made you revise your target?

GM: We were pleasantly surprised by the resource estimate. Alderon reported an Indicated iron ore resource of 490 (Mt), plus an inferred resource of 118 Mt. Just today, the company brought out some drill-hole results on North Rose, which is outside the defined resources, and looks as though it has potential to add resources. Alderon did surprise on the upside and we give it some more credit on that basis.

TGR: What were your thoughts after visiting the property and meeting management?

GM: My take is that the management is made up of very strong group, and this is married with a very strong board. A significant component of the current board is that many were also on the board of Consolidated Thompson during its pre-production stages.

In terms of the property, it’s all location, location, location for infrastructure. The Kami property is within 15 miles of four operating mines with four options to get to a public rail system. Those components work well together for this project.

TGR: Would those factors make it a takeover target?

GM: It has potential. The main other component is that it is independently owned. There are no steel producers involved in the company at the moment. Its largest shareholder is Altius Minerals Corporation (TSX.V:ALS) because it originally held the property. I definitely think Alderon could be a potential takeout candidate in the long term.

TGR: Are there some other promising juniors that you follow?

GM: Another independent iron ore company in that same mining area is Champion Minerals Inc. (TSX:CHM). It has a portfolio of projects with around 1.5 billion tons of NI 43-101 compliant resources. Its flagship project, Fire Lake North, is not too far away from ArcelorMittal (NYSE:MT) existing Fire Lake Mine. Champion potentially still needs a little more infrastructure to come into play, but it has a very good portfolio of assets going forward. We have a target of $4.20 for Champion stock. Recently, it was trading at about C$2.38.

TGR: Any other juniors in the Labrador Trough there?

GM: I mentioned Labrador Iron Mines, which is entering production this year. It probably will produce just less than 1.5 Mt. of 62% direct shipping iron ore style product.

TGR: Who are the major shareholders in that play?

GM: The main shareholder is Anglesey Mining Plc. (LYSE:AYM). The second major shareholder is Passport Capital.

There is also New Millennium Capital Corp., which has a joint-venture project with Tata Steel, its largest shareholder.

TGR: Given Tata’s large stake in New Millennium, it’s probably not a takeover target. But are Champion and Labrador?

GM: Alderon, Champion and Labrador all have the potential to be taken out.

We are also looking at Northland Resources being one of the next producers, although it isn’t in the Labrador Trough.

TGR: Where is that project located?

GM: It has two projects. Its flagship is the Kaunisvaara project in Sweden, which is fully permitted for production, and is in development at the moment.

Sweden has a long history of iron ore mining. This project would export out of Norway, and would probably be predominately selling to a European market. The project is expected to output a very high-quality product at around 69% Fe, and we think the company could fetch a good premium for the product.

TGR: What can investors expect in the iron ore market in the near term?

GM: Growth should continue to emanate out of China and India, and bolstered recovery is taking hold in Europe, particularly Eastern Europe, and North America. Another feature to look at is the cost of seaborne freight. There have been continuous lows in the market for seaborne freight because of surplus capacity that should continue for a number of years. Demand growth and lower transportation rates provide fantastic opportunities for pricing protection to moderate operating margins for projects entering production or at the development stage.

TGR: Thanks for your time, Geordie.

Dr. Geordie Mark, a research analyst with Haywood Securities, focuses on uranium companies involved in exploration, development and production. He joined Haywood from the junior exploration sector, where he was vice president of exploration for Cash Minerals, which concentrated on uranium and iron oxide-copper-gold targets across Canada. Prior to joining the exploration industry, Mark lectured in economic geology at Monash University, Australia, and served as an industry consultant. He completed his Ph.D. in geology in 1998 at James Cook University’s Economic Geology Research Unit in Australia, specializing in aqueous geochemistry and igneous petrology applied to ore-forming systems.

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DISCLOSURE:
1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Alderon.
3) Geordie Mark: I personally own shares of the following companies mentioned in this interview: Northland Resources. Haywood Securities, Inc. has reviewed lead projects of Alderon Resource Corp. and Champion Minerals Inc. and a portion of the expenses for this travel have been reimbursed by the issuer. Haywood Securities Inc. or an Affiliate has managed or co-managed or participated as selling group in a public offering of securities for Alderon Resource Corp. and Champion Minerals Inc. in the past 12 months.

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