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Message: Developments in the Iron Ore Market

BHP Billiton (BHP) shares have reached their lowest levels since 2008 after reports surfaced November 5 of a mining dam the company owns via a joint venture with Vale (VALE) broke. The dam failure has decimated a rural community, killed at least 8 people, left at least 20 people missing, and potentially contaminated the water source of hundreds of thousands of Brazilians.

Samarco, the limited liability company set up to operate the joint venture between BHP and Vale, has been said to be fully responsible for the failure, but the two-year old company may do little to protect its parent companies from hefty fines and cleanup and legal costs. According to an environmental lawyer, if Samarco cannot cover the cleanup and legal costs, the Brazilian government will then go after BHP and Vale. The Brazilian government has since vowed to make both companies pay for the failure of the dam. Environment Minister Izabella Teixeira said to reporters, “There will be punishment, and under Brazilian law the environment has to be repaired.”

Though BHP and Vale have not given an explanation as to what may have caused the dam to fail, prosecutors have already claimed that negligence played a material role in the breach. Further damning the parent companies is the reported evidence that supports the fact that Vale had been dumping mineral waste from its own iron ore mines into a waste reservoir in the dam system, providing additional, unnecessary pressure to the dam. This kind of evidence raises the question as to whether or not cost cutting efforts that have been prevalent across the mining sector played a role in the “negligence” that took place, and if other miners could potentially be faced with similar problems in the future.

Regardless of whether or not Vale and BHP were aware of the lack of proper oversight that was taking place at the joint venture, both are facing significant fines and cleanup costs. The total financial toll could end up being well over $1 billion, according to some estimates, but it is too early to accurately quantify the monetary damage facing the companies. Samarco has been forced to stop production and could be closed for anywhere from 18-36 months. Samarco makes up ~5% of BHP’s total earnings, and the production shutdown and simultaneous assessing of fines and cleanup costs will likely have significant impact on BHP’s dividend health.

If that wasn’t bad enough, BHP owes nearly $600 million to the Australian government in royalties and tax assessments due to the selling of Australian produced commodities through its Singapore marketing hub. Our outlook on the firm’s dividend was already very cautious, and these developments only make matters worse. Investors have taken notice, and the notion that a cut in the payout may be coming has contributed to BHP’s massive share slide in the past week. We’ve recently updated our 16-page reports and dividend reports on the group.

That said, the horrendous disaster in Brazil could offer a shred of hope for other iron ore producers such as Best Ideas Newsletter portfolio holding Rio Tinto (RIO). The iron ore supply glut spurred by producers like BHP and Rio Tinto, coupled with pressures on demand from China, the world’s leading iron ore user, has simply crushed iron ore prices. Though producers around the globe have been focused on cutting costs, Rio Tinto and BHP in particular had retained their resolve to continue to “pump the market with iron” at record production levels. Now, however, BHP and Vale will both face significant headwinds with respect to production expansion given the closing of Samarco, which accounts for over 20% of global iron ore pellet exports, according to estimates. Such an unfortunate incident as the dam break may serve as a catalyst to slow the drop in iron ore prices, or maybe even help stabilize them.

Rio Tinto’s relative balance-sheet strength, something we have been highlighting for some time, will be a key to it making it to the other side of the current downturn, especially in light of production plans. In the third quarter of 2015, for example, the company increased its global iron ore production by 12% on a year-over-year basis, and the torrid pace may continue. Stability in iron ore prices will be welcome news for Rio Tinto, even if it may be short-lived.

As many of our readers know, Rio Tinto is a very small weighting in the Best Ideas Newsletter portfolio and is largely held for diversification reasons (i.e. sector exposure to basic materials). In particular, the firm remains our favorite idea in the metals and mining industry, but we generally avoid price-taking, commodity-producing entities that are loaded with debt. We value shares of Rio Tinto at $46 each.

Interested in learning more about Valuentum? Please visit us at www.valuentum.com.

Related firms: GLEN, AAUKY

Metals & Mining - Diversified: BHP, CLF, FCX, RIO, SCCO, SLW, VALE

Kris Rosemann contributed to this article.

Valuentum (val∙u∙n∙tum) [val-yoo-en-tuh-m] Securities Inc. is an independent investment research provider, offering premium equity reports and dividend reports, as well as commentary across all sectors/companies, a Best Ideas Newsletter (spanning market caps, asset classes), a Dividend Growth Newsletter, business/investing book reviews pre-public release, modeling tools/products, and more. Independence and integrity remain our core, and we strive to be a champion of the investor. Valuentum is based in the Chicagoland area.

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This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice. For more information about Valuentum and the products and services it offers, please contact us at info@valuentum.com.

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