EUR 850.00 For Business Accounts Only

Morningstar | Vale’s Tragic Tailings Dam Disaster Tightens the Near-Term Iron Ore Market

The failure of a tailings dam at Vale’s Corrego de Feijao iron ore mine in Brazil is a tragedy with more than 40 people confirmed dead and nearly 300 still missing. The dam was 86 metres high and contained approximately 12 million cubic metres of tailings, essentially wet sand, which flowed when the dam burst. Most of the victims were Vale employees, working in the mine’s processing plant and offices downstream of the dam.

The disaster comes just a few years after a similar failure at Vale’s 50%-owned Samarco iron ore operation. Given the likely flow-on impact to Vale’s supply from the loss of the mine and the planned suspension of production from mines with similarly designed tailings dams, we have raised our near-term iron ore price forecasts. The suspensions will impact about 40 million tonnes of production capacity while the tailings dams are remediated. Vale expects the remediation to take three years. The company intends to make up some of the lost production by expanding elsewhere, but the potential for regulatory pressure means the path to mitigate lost production is unlikely smooth. Also, the potential remediation standards Vale will either insist on or be held to post these disasters may see a permanent fix take longer and cost more than expected.

Interruptions to Vale’s supply compound recent small disruptions from BHP’s train derailment and a fire at a Rio Tinto port. Based on what’s known and likely, the impact to the iron ore market should be limited to the near to medium term. We raise our nominal iron ore fines price forecasts by 18% to USD 65 per tonne in 2019, 29% to USD 55 per tonne in 2020, and 5% to USD 40 per tonne from 2021. Our midcycle assumption remains USD 40 per tonne. Our fair value estimate for Fortescue rises 10% to AUD 4.20 per share, Rio Tinto by 6% to AUD 55 and BHP by 2% to AUD 25.50. For Vale, we lower our fair value estimate by 6% to USD 8.80 with higher iron ore prices only a partial offset to the expected liabilities.

Our 6% lower fair value estimate for Vale incorporates 25 million tonne per year reductions in our sales volume’s forecasts to 370 million tonnes in 2019, 380 million tonnes in 2020 and 390 million tonnes in 2021, respectively, normalising to an unchanged 425 million tonnes by 2023. The reductions represent approximate 6% declines for the next three years versus our prior forecasts and nearly 2% of global traded iron ore supply. The reductions factor in some regulatory and reputational challenges which could slow Vale’s ability to ramp up output elsewhere to compensate. We’ve also incorporated a USD 5 billion pretax liability for the disaster, spread over the next three years. This uses the estimated cost of the Samarco disaster as a guide and Vale’s planned USD 1.3 billion of tailings dam remediation costs. There is significant uncertainty around the likely quantum and timing of any cash flows for remediation, compensation and damages.

At this stage, the full impact of the interruptions on iron ore market is unknown. That said, it’s instructive to give some sensitivities around our base-case assumptions for the key iron ore miners positioned to benefit at Vale’s expense. If we increase all commodity prices by 10% from our base case, our fair value estimates for BHP, Rio Tinto and Fortescue increase by 12%, 15% and 16% respectively. If we flex just the iron ore price, our fair value estimates would increase by approximately 5%, 8%, and 16%, respectively, reflecting the relative importance of iron ore to each firm. These sensitivities assume for every USD 2 increase in revenue, there is a commensurate USD 1 increase in operating costs. This assumption is consistent with the historical correlation between prices and costs, and in line with the methodology used in our June 2018 report entitled “What’s Priced into the Major Miners.” Our base case iron ore price forecasts are USD 65 per tonne in 2019, USD 55 per tonne in 2020, and USD 40 per tonne from 2021 onwards.

The disaster is likely to only limit Vale’s production in the near to medium term. The direct impact from the loss of output from the Corrego de Feijao iron ore mine is relatively small. It only produces around 8 million tonnes of iron ore, versus the global traded market of around 1.5 billion tonnes. However, given this is Vale’s second disaster in relatively short order, and it came despite a heightened focus on dam safety after Samarco, the general public is likely to be sceptical of Vale’s proposed remedies. The Brazilian government is also likely to be pressured to act. Increased inspections and remediation activities may impact Vale’s output more broadly.

Supporting our expectation for greater scrutiny, Vale says it will decommission and remediate all tailings dams which were constructed using the upstream method. The upstream method of construction involves walls being sequentially built on top of tailings as the level of the dam rises. The method was common to both the Samarco and Feijao failures. Vale has 10 such dams and will halt production at all mines linked to the dams while it completes the permanent remediation. The company expects this to impact approximately 40 million tonnes of production, cost approximately USD 1.3 billion and take three years to complete.

Elevated iron ore prices raise the possibility of a medium-term supply response. We think Mineral Resources is a front runner with its ambitions to add 30 to 50 million tonnes of new production. The firm has substantial financial firepower with a recent asset sale for USD 1.15 billion. There’s also a chance the large, high-grade greenfield Simandou deposit in Africa could be developed with funding from China. The mine is hard to justify financially given the high up-front cost and low likely returns but would give Chinese iron ore consumers a key supply lever to influence the market. Given the disruptions to Vale’s supply are likely to be temporary, and the potential for new supply increases with the prevailing high prices, we think the benefit to the iron ore miners will be temporary. The near-term outlook for earnings for the major iron ore miners is positive but the share price moves mean it is more than reflected in market valuations.

The disaster comes on the heels of the catastrophic failure of the iron ore tailings dam at Samarco in November 2015. Samarco 50% owned by BHP and 50% by Vale. The latest failure at Corrego de Feijao by comparison involves a smaller tailings discharge but has come at a much greater cost to human life. The Samarco disaster released approximately 60 million cubic metres of tailings and saw 19 fatalities. Corrego de Feijao released about 12 million cubic metres of tailings but sees more than 40 people confirmed dead and nearly 300 still missing.

For Vale, having a second tailings dam failure so soon after Samarco’s means the scrutiny from the public and government is likely to be substantially higher this time around. For Vale, there will be a direct financial impact in terms of fines, clean-up costs, compensation to the victims and likely lawsuits for damages. For Samarco, approximately USD 1.6 billion had been spent by end 2018 to remediate the disaster and at the end of June 2018, Samarco had a further discounted liability of USD 2.6 billion outstanding on its balance sheet. This represents an approximate USD 4 billion liability for Samarco, and there’s still potential for that cost to rise.