Metals & Mining Iron Ore Cycles and Volatility

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1 INDUSTRY NOTE UK Natural Resources Iron Ore Cycles and Volatility Key Takeaway While the iron ore market avoided its typical seasonal weakness in August, the price has begun to drift lower as destocking has likely begun and supply growth from Australia has started ramping up. However, we expect the price to strengthen heading into Q1 214 due to seasonal supply disruptions and improving underlying demand, and we would buy shares of iron ore leveraged companies including Rio Tinto, BHP Billiton and ArcelorMittal on any nearterm weakness. Chinese steel market strength: Chinese steel markets have been stronger than expected over the past two months. While Chinese steel prices have more recently begun to drift lower and may decline further in the very short-term, our detailed analysis in this report indicates that the medium-term fundamental outlook for Chinese steel demand has significantly improved. Pent up demand for steel in the Chinese property markets in particular, which account for about 36% of Chinese steel consumption, could lead to much stronger than expected steel demand over the next two years. EQUITY RESEARCH EUROPE Iron ore destock in China is coming but should be moderate: Since the end of August, Chinese domestic steel prices have declined and steel production margins have contracted. With margins getting squeezed and with anecdotal evidence that Chinese steel mills currently hold around two months of iron ore inventory (which is higher than the normal 3-4 days), it is possible that there is some moderate destocking of iron ore in the weeks ahead as mills look to reduce working capital in an effort to protect cash flows. A Chinese iron ore inventory destock would likely be a negative for the iron ore price as China accounts for about 65% of demand for seaborne iron ore. Seaborne iron ore supply is rising for now: Australian miners Rio Tinto, BHP Billiton and Fortescue are all ramping up iron ore production from ongoing growth projects. This incremental supply has put some downward pressure on iron ore spot prices while Baltic freight rates have skyrocketed. The combination of an end market destock and a ramp-up of new capacity should lead to lower iron ore prices for now. But seasonal factors in 1Q should lead to higher prices: The iron ore market has extreme seasonal swings, with significant supply disruptions almost always occurring in Q1. Over the past three years, for instance, Chinese iron ore production has fallen by 22% on average from Q4 to Q1, Australian iron ore production has fallen by 11% on average from Q4 to Q1, and Brazilian iron ore production has fallen by 25% on average from Q4 to Q1 due to weather related supply issues in January and February. Seasonal supply issues in Q1 214 are likely to once again lead to a tighter iron ore market, higher iron ore prices and higher mining share prices. In our experience, many investors typically misinterpret seasonal swings and inventory cycles as being real fundamental changes to the iron ore market. This misinterpretation often leads to volatility in share prices of iron ore miners, providing opportunity to trade iron ore's seasonality in the equity markets. Buy Rio Tinto, BHP Billiton and ArcelorMittal on any near-term weakness: We expect the market to at least partially misinterpret near-term inventory destocking and Q1 seasonal supply issues in iron ore as real changes to underlying fundamentals in the Chinese steel markets. We would buy shares of Rio, BHP and Mittal on any near-term weakness as higher iron ore prices in Q1 should lead to increased positive sentiment and a wave of consensus earnings upgrades for these companies. Christopher LaFemina, CFA * Equity Analyst +44 () clafemina@jefferies.com Seth Rosenfeld, CFA Equity Analyst +44 () srosenfeld@jefferies.com Adrian Lunt Equity Analyst alunt@jefferies.com Ruoou Gu, CFA * Equity Associate (212) ruoou.gu@jefferies.com * Jefferies LLC Jefferies International Limited Jefferies Singapore Limited MCI (P) 35/7/213 Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-us analysts on pages 21 to 24 of this report.

2 Chinese Steel Markets: Stronger Than Expected Chinese steel production and steel demand have significantly surprised to the upside this year. Crude steel production in China surged to an all-time record run-rate of 8mtpa in May, and has remained in the 76-8mtpa range since then. This compares to full year 212 production of 717mt. Chinese steel production has consistently been in the 76-8mtpa run rate for most of this year versus full year 212 production of 717mt. We would attribute the high run rates of the past two months in particular to lower than expected maintenance-related output cuts and stronger than expected underlying demand. Exhibit 1: Chinese Annualised Daily Steel Production, YTD million tonnes Jan 1-1 Jan Feb 11-2 Mar 1-1 Mar Apr 11-2 May 1-1 May Jun 11-2 Jul 1-1 Jul Aug 11-2 Sep 1-1 Source: China Iron & Steel Association, Jefferies Moving into July and August, Chinese steel prices increased by about 1% from their June/July lows despite high Chinese steel production run rates, and China s typical and highly predictable seasonal steel market weakness simply did not materialise. Based on our analysis, there are a number of factors which may have contributed to these higher than expected Chinese steel production run rates and prices. These factors include the following: Some of the larger state-owned mills may have been competing for market share and would therefore have been reluctant to be the first to reduce output. As a result, the Chinese steel industry had lower than expected maintenance-related output cuts over the past two months. Some steel mills may have come to terms with the new normal of lower margins, and so maintained high output levels even for marginal gains, with production cuts unlikely to have been considered unless losses were substantial. Loss-making production at some mills may have been subsidised by local governments in order to maintain high employment levels and support GDP growth. Most importantly for our analysis, underlying demand also appears to have improved following China s SHIBOR shock in June, as evidenced by the rundown of finished steel inventory in China despite sustained high steel production run rates. Rising domestic steel prices in July and August likely incentivised mills to maximise production and defer maintenance outages. All things considered, we would argue that the outlook for Chinese steel demand and therefore seaborne iron ore demand has significantly improved in recent months. It is possible that Chinese steel production and demand continue to surprise to the upside, at least partly due to cyclical factors as China s economy appears to be recovering from the verge of a hard landing just three months ago. Notably, the China Iron & Steel Association (CISA) recently projected crude steel output to reach 78mt this year, 3mt above its initial projections and greater than our more conservative estimate of 766mt. In addition, steel demand from the property sector in China has the potential to significantly exceed the market s expectations, as we discuss later in this report. All things considered, we would argue that the outlook for Chinese steel demand and therefore seaborne iron ore demand has significantly improved in recent months. page 2 of 24

3 The spike in Chinese interest rates in June greatly increased the risk of a hard landing for China s economy. However, credit conditions have since stabilised as the PBOC injected liquidity into the banking system and order was subsequently restored. Exhibit 2: Overnight SHIBOR Rate, YTD % Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Source: Bloomberg, Jefferies Chinese macro data have recently surprised to the upside as the economy appears to have stabilised following what appeared to have been a path to a hard landing in June. Exhibit 3: Chinese Economic Surprise Index, YTD Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 *Above zero indicates positive surprise while below zero indicates negative surprise Source: Bloomberg, Jefferies The recovery in Chinese PMI from July to September is encouraging. PMI figures for the US, Europe and Japan have also recently moved into expansionary territory as a recovery in the global industrial economy appears to be underway. Exhibit 4: Chinese HSBC Flash PMI, Jan 212-Sep Source: Bloomberg, Jefferies page 3 of 24

4 China should become less steel intensive over time as the country transitions from fixed asset investment-driven to consumerdriven economic growth. It is possible though that a strong recovery in construction leads to a longer than expected period of strong demand for steel in China. Medium-term outlook for Chinese steel demand remains robust The medium-term outlook for Chinese steel production and demand is always quite unpredictable. Our base case assumption is that China s economy will gradually become less steel intensive as the ratio of steel demand growth to GDP growth should fall over time. There is risk that this decline will be more abrupt than we are forecasting as some of China s steel demand may have effectively been pulled forward from future periods as massive steel-intensive fixed asset investment has led to overcapacity in many steel end markets. On the other hand, it is also possible that a strong recovery in construction leads to a longer than expected period of strong demand for steel and greater than expected growth in Chinese steel production. Just three months ago we would have argued that this upside potential is highly unlikely, but things have clearly changed since then. Analysis of the China s steel consumption per capita relative to GDP per capita (the Scurve ) would indicate that China s steel intensity has yet to reach its peak. While we do not expect China s steel intensity to rise to the levels of an export-focused economy such as South Korea, there still appears to be further upside from current levels as China s urbanisation and industrialisation continues. To be clear, we do expect the country to become less steel intensive over time as the country s economic growth becomes less fixed asset-intensive and more consumer-driven. However, we expect this to be a gradual, multi-year re-balancing process, and it is possible that steel demand over the next 2-3 years may exceed current market expectations. As China s economic growth has been mostly investment-driven, consumption (including government consumption) accounts for only about 44% of China s economy. Chinese household consumption accounts for less than 35% of the country s GDP. To put this in perspective, household consumption accounts for about 7% of GDP in the US. Over time, consumption should become a more significant driver of Chinese GDP growth, and China s economy should therefore become less steel-intensive. Exhibit 5: Average Contribution to China's GDP, 2-13E Net Exports of Goods and Services, 3% Gross Capital Formation, 53% Final Consumption Expenditure, 44% *Final Consumption Expenditure consists of Household Consumption Expenditure and Government Consumption Expenditure **Gross Capital Formation Consists of Gross Fixed Capital Formation and Change in Inventories Source: Bloomberg, National Bureau of Statistics China, Jefferies estimates Every unit of fixed asset investment is on average about 12x as steelintensive as every unit of consumer spending. China s strong growth in fixed asset investment over the past decade has therefore resulted in very strong growth in China s demand for steel. China s fixed asset investment growth, while still very high at about 2% y/y in recent months, has fallen over the past few years and is likely to gradually fall further in the years ahead. Exhibit 6: Chinese Fixed Asset Investment (billion RMB, y/y%), 2-13E 35% 3% 25% 2% 15% 1% 5% % E Source: National Bureau of Statistics China, IMF, Jefferies estimates page 4 of 24

5 While it is unlikely that China s steel intensity will rise to the levels of an export-focused economy such as South Korea, China s steel consumption per capita should continue to increase as GDP per capita increases over time. This Scurve has proven to be a fairly accurate predictor of Chinese steel consumption. Exhibit 7: Historical Steel Consumption per Capita versus GDP per Capita, Apparent steel consumption (kg per capita) 1,4 1,2 1, South Korea Japan Germany 2 China United States 5, 1, 15, 2, 25, 3, 35, 4, 45, 5, GDP per capita (US$) China Japan South Korea United States Germany Source: World Steel Association, World Bank, Jefferies China s urbanisation should continue to be a key driver of Chinese steel demand for the rest of the decade its urbanisation rate of 53% is still well below the 8% norm among developed economies. According to the World Bank, 7% of the population is expected to live in cities by 23, and by 225 there will be 225 million cities with over one million inhabitants. China s policymakers also expect this ongoing urbanisation process to continue for many years. The key point here is that while there are risks, the decline in steel intensity of China s economy is likely to be gradual, which implies that Chinese steel demand should grow at a slower rate but from an ever increasing base. China s urbanisation rate of 53% is still well below the 8% norm among developed economies. The World Bank projects that China s urbanisation rate will reach 7% by 23, and China s policymakers also expect this urbanisation process to continue for many more years. Exhibit 8: China Urban versus Rural Population, millions 1, Urban population Rural population Urbanisation rate (RHS) 6% 5% 4% 3% 2% 1% % Source: Bloomberg, National Bureau of Statistics, Jefferies page 5 of 24

6 Pent up demand for steel in Chinese property markets In our Chinese steel demand model (see Exhibit 11), we forecast slowing construction (property and infrastructure) growth in the coming years, assuming steel demand growth in construction of 2.9% in 214 and 2.% in 215. Our assumption for steel demand growth from the Chinese property market which accounts for about 36% of Chinese steel consumption is even more conservative at 1.3% in 214 and.9% in 215. Notably though, property sold over the past year has greatly exceeded new construction starts, indicating a destocking has taken place in the Chinese property market. Furthermore, Chinese domestic loans for real estate investment have increased significantly over the past year as the government has loosened controls on the property sector. It is very possible that there will be a restocking cycle in the Chinese property markets, and steel demand from the property sector could significantly exceed current conservative expectations as a result. Property sales have greatly exceeded new construction starts over the past year, indicating destocking has taken place in the Chinese property market. A restocking cycle in the Chinese property markets could lead to much stronger than expected Chinese steel demand. Exhibit 9: Chinese Floor Place Sold versus New Construction Starts (y/y % change), % New Starts Floor space sold Source: Bloomberg, National Bureau of Statistics, Jefferies Lending to real estate developers has increased significantly over the past year as the government has loosened controls on the property sector. This increased lending should lead to an acceleration of growth in property investment. Exhibit 1: Chinese Domestic Loans for Real Estate Investment (y/y % change), % Aug-7 Aug-8 Aug-9 Aug-1 Aug-11 Aug-12 Aug-13 Source: Bloomberg, National Bureau of Statistics, Jefferies page 6 of 24

7 Exhibit 11: Chinese Steel Supply and Demand, E (million tonnes) E 213E 214E 215E (million tonnes) Crude Steel Production YoY % Change 18.3% 16.3% 4.6% 12.6% 1.7% 8.8% 3.1% 7.% 4.3% 3.1% Implied Crude Steel Imports Implied Crude Steel Exports Implied Crude Steel Demand YoY % Change 9.5% 11.7% 5.6% 22.1% 7.3% 7.9% 2.% 7.% 4.3% 3.1% Implied Change in Inventory Crude Steel Consumption YoY % Change 8.7% 1.8% 6.8% 23.4% 6.6% 6.2% 3.6% 7.1% 4.3% 3.1% Convert Rate 96.% 96.% 96.% 96.% 96.% 96.% 96.% 96.% 96.% 96.% Apparent Steel Use YoY % Change 8.7% 1.8% 6.8% 23.4% 6.6% 6.2% 3.6% 7.1% 4.3% 3.1% Demand by End Market (million tonnes) E 213E 214E 215E Non-Construction Automobiles Appliances Capital Goods Other Total Non-Construction YoY % Change 22.8% 9.4% 4.8% 6.9% 23.1% 13.4%.1% 11.% 6.1% 4.4% Construction Infrastructure Property YoY % Change in Property -.8% 7.8% 9.9% 4.1% -5.3% 3.3% 3.1% 5.% 1.3%.9% Total Construction YoY % Change in Construction.2% 11.8% 8.2% 34.9% -2.6% 1.2% 4.2% 6.3% 2.9% 2.% Total Steel Demand Total Steel Demand (y/y % change) 8.7% 1.8% 6.8% 23.4% 6.6% 6.2% 2.4% 8.3% 4.3% 3.1% Chinese GDP growth 1.4% 11.2% 6.8% 1.7% 9.8% 8.9% 7.9% 7.5% 7.5% 6.5% Non-Construction as a % of total 42.4% 41.8% 41.% 35.6% 41.1% 43.9% 42.9% 43.9% 44.7% 45.3% Construction as a % of total 57.6% 58.2% 59.% 64.4% 58.9% 56.1% 57.1% 56.1% 55.3% 54.7% Source: China Ministry of Commerce, CISA, Bloomberg, MySteel, Company data, Jefferies estimates page 7 of 24

8 Near-term domestic steel price pressures likely to continue Following several weeks of rising prices, Chinese domestic steel prices have been in decline since late August as production has remained high while the seasonal increase in consumption that usually occurs in September and October has yet to kick in. Steel demand is unlikely to vary significantly in Q4, in our view. In absence of production cuts, and with steel exports unlikely to increase significantly, steel inventories are likely to increase after recent declines, and pressure is likely to remain on domestic steel prices and steelmakers margins. As discussed in the next section of this report, this may lead to some iron ore inventory destocking in the near term. Chinese domestic steel prices have fallen in recent weeks. We expect continued pricing pressure to weigh on steelmakers margins in the nearterm, which may lead to some raw material destocking. Exhibit 12: Chinese Domestic Steel Prices, YTD RMB per tonne 4,4 4,2 4, 3,8 3,6 3,4 3,2 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 HRC Rebar *Includes 17% VAT Source: Steel Business Briefing, Jefferies Exhibit 13: Chinese Steel Inventory Rebar, million tonnes Sep-1 Sep-11 Sep-12 Sep-13 *Includes inventory data from steel mills and traders, and excludes finished steel inventory held by end users Source: Bloomberg, Shanghai Steelhome, Jefferies estimates Exhibit 14: Chinese Steel Inventory HRC & CRC, million tonnes Sep-1 Sep-11 Sep-12 Sep-13 *Includes inventory data from steel mills and traders, and excludes finished steel inventory held by end users Source: Bloomberg, Shanghai Steelhome, Jefferies estimates page 8 of 24

9 Despite greater than expected recent imports of iron ore in China, iron ore inventories at Chinese ports have remained low. While we estimate there was some restocking at steel mills in July and August, this low inventory level at ports indicates that underlying demand has also been stronger than expected. Exhibit 15: Chinese Iron Ore Inventories at Ports, million tonnes Source: Bloomberg, Shanghai Steelhome, Jefferies There is relatively high risk that rebar prices in China drift lower in the near-term and the iron ore price is likely to drift lower as well. Exhibit 16: Iron Ore Price and Shanghai Rebar Price, YTD $/tonne RMB/tonne Correlation - 9% Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Iron Ore SH Rebar (RHS) Source: Bloomberg, The Steel Index, Antaike, Jefferies page 9 of 24

10 We would attribute recent iron ore price strength to a combination of stronger underlying demand and restocking at mills. Iron Ore Restocking in China Likely Over May Be Time for a Moderate Destock As discussed above, Chinese steel production and iron ore prices significantly exceeded expectations in recent months. We would attribute this to a combination of stronger than expected underlying demand and some restocking after steelmaker margins improved in May and June (when the decline in iron ore prices outpaced that of steel prices). We estimate that total Chinese iron ore inventories across mills and ports increased by almost 13mt in July and August. Since the end of August, Chinese domestic steel prices have declined and steel mills margins have contracted. With margins getting squeezed and with anecdotal evidence that mills currently hold around two months of iron ore inventory (which is higher than the normal 3-4 days), it is possible that there is some moderate destocking of iron ore in the weeks ahead as mills look to reduce working capital in an effort to protect cash flows. We estimate that total Chinese iron ore inventories increased by almost 13mt in July and August. Exhibit 17: Total Iron Ore Inventory Changes in China, YTD million tonnes 1 5 (5) (1) (15) (2) Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 *Reported port inventory and estimated inventory held at steel mills Source: Bloomberg, National Bureau of Statistics, Customs General Administration PRC, Shanghai Steelhome, Jefferies estimates Chinese steelmaker margins have contracted in recent weeks as domestic steel prices have tumbled. With mills estimated to hold around two months of iron ore supply, it is possible we may see some moderate destocking in the near-term. Exhibit 18: Chinese Long Steel Spread over Raw Materials (IODEX), YTD US$/t Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 *Raw materials include iron ore and hard coking coal Source: Steel Business Briefing, Jefferies page 1 of 24

11 In recent years, the seaborne iron ore price has typically only traded at a premium to the Chinese domestic price in the winter months when domestic iron ore supply is heavily impacted by weather-related disruptions. On the other hand, seaborne prices have tended to suffer relative to domestic prices during periods of destocking. With prices now broadly aligned, seaborne supply plentiful, and the potential for some moderate destocking looming, it is possible that seaborne prices could again temporarily fall below domestic prices. In recent years, seaborne iron ore prices have typically traded at a premium to domestic prices during periods of domestic supply constraints. On the other hand, seaborne prices have typically fallen relative to domestic prices during periods of destocking. Exhibit 19: Seaborne versus Chinese Domestic Iron Ore Price (exc. VAT, 62% Fe equivalent) Sep-21 Mar-211 Sep-211 Mar-212 Sep-212 Mar-213 Sep-213 Seaborne iron ore (US$/tonne) Chinese domestic iron ore (US$/tonne) *Chinese domestic iron ore price is the Hebei/Tangshan spot price (66% Fe concentrate), adjusted for grade and VAT Source: Bloomberg, The Steel Index, Antaike, Jefferies estimates Seaborne iron ore supply has risen in recent weeks While some inventory destocking at steel mills could put moderate downward pressure on iron ore prices in the near-term, supply-side dynamics may also play a role. Based on our analysis, seaborne iron ore supply has increased in recent weeks as major miners have begun to ramp up shipments from growth projects and existing stockpiles may also have been sold down. This is somewhat evidenced by the sharp rise in the Baltic Dry Index, a composite of the Baltic Capesize, Panamax, Handymax and Supramax indices which measures the demand for shipping capacity versus supply of dry bulk carriers. Since the end of August, the BDI has risen 68%, indicating a significant rise in demand for vessels. The Baltic Dry Index has risen 68% since the end of August. Our analysis indicates that this is due in part to increased shipments from major miners ramping up volumes as well as some liquidation of existing stockpiles at Australian ports. Exhibit 2: Baltic Dry Index, YTD Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Source: Bloomberg, Jefferies page 11 of 24

12 Higher seaborne iron ore shipments in September may be due to the commissioning of major miners growth projects as well as some sell-down of inventory. Iron ore shipments from Port Hedland, which is used by BHP Billiton and Fortescue, both of which are in the process of commissioning growth projects, totaled 27.4mt in August, up 2% YoY. Rio Tinto meanwhile loaded first shipment from its expansion to 29mtpa in early September. In addition, Rio notably produced 8.6mt more iron ore than it shipped in 1H13 as its operations were impacted by weather-related disruptions as well as a conveyor belt breakage at Cape Lambert. At Rio s recent investor site visit, management indicated that there was approximately 25mt of stockpiled iron ore in the Rio Tinto system at the time, of which about one-third was at the port. It is possible that increased shipping volumes are partially due to some liquidation of inventory at Rio s ports. In short, our analysis indicates that the iron ore price is likely to be under some further downward pressure in the nearterm due to a combination of potential destocking at mills and an increase in seaborne supply. Port Hedland, used by BHP Billiton and Fortescue, both of which are in the process of commissioning growth projects, saw total iron ore shipments of 27.4mt in August, up 2% YoY. Exhibit 21: Port Hedland Iron Ore Shipments, million tonnes % 5% 4% 3% 2% 1% % -1% Export Volumes YoY change (RHS) Source: Port Hedland Port Authority, Jefferies page 12 of 24

13 Seasonality Still Matters The iron ore market has historically largely been a contract market in which prices were negotiated annually between buyer and seller. As such, seasonality had little impact on price realisations over the past few decades. In the past two years though, the spot market has become much more relevant, and the spot price is now broadly representative of market clearing prices. As the spot market has become more important, the price has also become more volatile. Based on our analysis, this volatility is largely due to inventory cycles and seasonal factors rather than changes in underlying fundamentals. Most analysis of the iron ore market is done on an annual basis, but it is important to remember that this is an extremely seasonal market. For instance, the iron ore price averaged $129 per tonne in 212 and has averaged $136 per tonne so far this year. It could therefore be said that on average, prices have been relatively stable over the past couple of years. However, this would mask iron ore s tremendous price volatility over the period. In 212, the price variance between peak and trough during the year was $63 per tonne, while the peak to trough variance in 213 has been $49 per tonne, despite the YTD average being just $7 per tonne higher than last year s average price. Seasonality is critically important - particularly as we approach the January-February period. On average, iron ore prices have been relatively stable over the past two years with the 213 YTD average just $7/t above last year s average price. However, this masks the significant volatility caused by inventory cycles and seasonal factors. In 212, the peak to trough spot price variance was $63/t, while the peak to trough variance in 213 has been $49/t. Exhibit 22: Historical Iron Ore Price (62% Fe fines equivalent, CFR China), $/tonne $175 $165 $155 $145 $135 $125 $115 $15 $95 $ avg: $129/t 213 YTD avg: $136/t $75 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Source: Bloomberg, The Steel Index, Jefferies Iron ore production is typically greatly impacted by weather-related supply disruptions during January and February. We expect these seasonal supply issues to happen once again this year. We expect seasonal supply constraints to be an issue again this winter. Chinese iron ore production typically does not increase much from Q3 to Q4 due to the onset of winter, and almost always declines from Q4 to Q1 as harsh winter weather, particularly in northern China, hampers production and transportation. Heavy snowfall often impacts mining operations, while freezing conditions make separation processes more difficult. In the past three years, Chinese domestic iron ore production has declined by 22% on average from Q4 to Q1. page 13 of 24

14 In the past three years, Chinese domestic iron ore production has declined by 22% on average from Q4 to Q1 as a result of weatherrelated disruptions. Exhibit 23: Chinese Domestic Iron Ore Production million tonnes /11 11/12 12/13 Q4 Q1 Q2 Q3 Source: Bloomberg, National Bureau of Statistics, Jefferies Australia and Brazil also experience significant seasonal supply disruptions. Iron ore supply from both countries typically declines from Q4 to Q1 due to cyclones and wet weather in general. Over the past three years, iron ore exports from Australia and Brazil declined on average from Q4 to Q1 by 11% and 25%, respectively. A seasonal decline in Australian and Brazilian production could be a material positive for the iron ore price as these two countries account for more than three quarters of seaborne iron ore supply. Australian iron ore exports have declined by 11% on average from Q4 to Q1 over the past three years. Exhibit 24: Australian Iron Ore Exports million tonnes /11 11/12 12/13 Q4 Q1 Q2 Q3 Source: Bloomberg, Australian Bureau of Statistics, Jefferies Brazilian iron ore exports have declined by 25% on average from Q4 to Q1 over the past three years. Exhibit 25: Brazilian Iron Ore Exports million tonnes /11 11/12 12/13 Q4 Q1 Q2 Q3 Source: Bloomberg, Ministerio do Desenvolvimento, Jefferies page 14 of 24

15 While significant new capacity is scheduled to come online by the end of this year, significant new supply will likely not. Due to weatherrelated supply disruptions, the impact of this new supply may not be fully felt until March 214 at the earliest. One important consideration is that of supply growth. There is a significant amount of new capacity scheduled to come online by the end of this year. However, whilst significant new capacity will indeed come online, significant new supply will most likely not be. Due to weather-related disruptions, we expect that much of this new capacity may not be truly impactful in the market until March next year at the earliest. Furthermore, some of the junior iron ore miners, such as African Minerals and Bellzone Mining for example, are now looking set to deliver less tonnes to the market this year than originally planned. Based on our detailed bottoms-up seaborne iron ore supply/demand model, we no longer expect a large surplus to emerge in 214. Recent developments have pushed this surplus back to It is also important to consider the elasticity of Chinese domestic iron ore miners operating costs to lower iron ore prices. Within China s domestic iron ore industry, cost inflation appears to be reversing and according to the Metallurgical Mines Association of China, the average domestic cost of production is currently around $15 per tonne for iron ore concentrate. While deeper mines and declining ore grades present a significant challenge, it is notable that taxes of $33-49 per tonne make up a significant portion of miners total production costs. Domestic iron ore miners are currently lobbying the government for tax cuts in order to support their survival amid the much anticipated future supply glut and lower pricing environment. Should this lobbying be successful, tax cuts over the next couple of years would likely lead to further marginal cost deflation and in turn lower iron ore prices, possibly well below our current price forecasts. page 15 of 24

16 Near-term Weakness would be Buying Opportunity As discussed above, declining steel prices, rising iron ore supply and some potential destocking of iron ore inventory at steel mills may lead to lower iron ore prices in the near-term. However, we expect a strong seasonal recovery to take place moving into the New Year as steel mills restock ahead of the winter months and supply disruptions manifest in January and February. The performance of the FTSE Mining Index has tracked the iron ore spot price quite closely this year. The iron ore price tends to be viewed as a proxy for China s industrial activity and general sentiment towards the sector. However, it is important to note that the iron ore price is subject to swings in sentiment, seasonality and inventory cycles. Movements in the iron ore price are therefore not always representative of changes in underlying fundamentals. This volatility may enable investors to trade the iron ore market s seasonality in the equity markets. We would argue that any significant near-term iron ore price weakness would represent a temporary departure from underlying fundamentals. The FTSE Mining Index has historically tracked the iron ore spot price closely as iron ore pricing is seen to reflect general sentiment on the sector. However, the iron ore price is subject to swings on sentiment, seasonality and inventory cycles, and is not always representative of underlying fundamentals. This provides investors with opportunity to trade iron ore s seasonality through the equity markets. Exhibit 26: FTSE Mining Index versus the Iron Ore Spot Price, YTD Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 FTSE Mining Index Iron ore (62% Fe fines, CFR China)(RHS) US$/t Source: Bloomberg, The Steel Index, Jefferies If mining equities follow iron ore prices lower in the coming weeks, we would view this as an attractive buying opportunity and recommend buying shares of Rio Tinto on a pullback. If mining equities follow iron ore prices lower in the near term, we would consider this to be a compelling buying opportunity. Based on our analysis, investor expectations over the next six months fail to fully appreciate the seasonality of the iron ore price. While we forecast a lower iron ore price on average in 214 ($115 per tonne, with risk to the upside), we expect a year of two very different halves with high prices in Q1 (possibly peaking at well above $15 per tonne) to be followed by much lower prices later on in the year. The iron ore swaps assessment does not reflect the likely seasonal strength in iron ore prices in 1Q14. Exhibit 27: Platts IODEX OTC Swaps Assessment (62% Fe, CFR North China) US$/t 13 Current spot: $132/t Q13 1Q14 2Q14 Source: Platts, Jefferies page 16 of 24

17 Within our large-cap European mining coverage, Rio Tinto would be the biggest beneficiary of a stronger than expected iron ore price, and we would especially recommend buying shares of Rio Tinto upon any trading weakness in the coming weeks. ArcelorMittal and BHP Billiton should also benefit from a period of higher than expected iron ore prices in 1Q14. Within our large-cap European mining coverage, Rio Tinto is best positioned to benefit from a stronger than expected iron ore price in 1Q14. BHP Billiton and ArcelorMittal should also benefit from a period of higher than expected iron ore prices. Exhibit 28: Iron Ore Price Sensitivity, 214E-15E (calendar year) Rio Tinto Iron Ore Price EBITDA EPS EV/EBITDA P/E US$ per tonne 214E 215E 214E 215E 214E 215E 214E 215E 1 18,976 22, x 5.x 11.4x 9.2x 11 2,854 24, x 4.5x 9.9x 8.1x ,796 25, x 4.2x 9.2x 7.6x 12 22,739 26, x 4.x 8.7x 7.2x 13 24,629 28, x 3.7x 7.7x 6.5x 14 26,523 3, x 3.3x 7.x 5.9x 15 28,423 32, x 3.1x 6.4x 5.4x 16 3,325 34, x 2.8x 5.8x 5.x BHP Billiton Iron Ore Price EBITDA EPS EV/EBITDA P/E US$ per tonne 214E 215E 214E 215E 214E 215E 214E 215E 1 3,724 34, x 5.3x 11.8x 1.1x 11 32,334 36, x 4.9x 1.9x 9.3x ,14 37, x 4.8x 1.5x 9.x 12 33,945 38, x 4.6x 1.1x 8.7x 13 35,556 39, x 4.4x 9.5x 8.1x 14 37,167 41, x 4.1x 8.9x 7.6x 15 38,778 43, x 3.9x 8.3x 7.2x 16 4,389 45, x 3.7x 7.9x 6.8x ArcelorMittal Iron Ore Price EBITDA EPS EV/EBITDA P/E US$ per tonne 214E 215E 214E 215E 214E 215E 214E 215E 1 7,327 1, x 3.6x 3.2x 8.8x 11 7,582 1, x 3.5x 25.7x 8.4x 115 7,71 1, x 3.4x 23.9x 8.1x 12 7,838 1, x 3.3x 22.4x 7.8x 13 8,93 11, x 3.2x 19.8x 7.3x 14 8,348 11, x 3.x 17.8x 6.8x 15 8,64 12, x 2.9x 16.1x 6.4x 16 8,859 12, x 2.8x 14.7x 6.x *EBITDA values are in US$m, EPS values are in US$ **All figures are based on calendar year, though BHP Billiton report to a fiscal year different to the calendar year ***All EV/EBITDA multiples are based on consolidated values ****In the case or ArcelorMittal, steel price assumptions are flexed in line with iron ore price changes *****All other commodity prices assume Jefferies formal forecasts ******Priced as of market close, 2 September 213 Source: FactSet, Jefferies estimates page 17 of 24

18 Exhibit 29: Seaborne Iron Ore Supply and Demand, E (million tonnes) E 214E 215E 216E Seaborne Supply Australia Brazil India South Africa Canada Sweden West Africa Other Total Supply ,31 1,61 1,131 1,325 1,48 1,516 y-o-y % 5.5% 15.9% 6.8% 9.6% 12.% 1.8% 2.7% 3.9% 2.9% 6.6% 17.2% 6.2% 7.7% Seaborne Demand China y-o-y % 4.5% 32.3% 18.5% 17.6% 15.8% 41.4% -1.4% 11.% 8.5% 5.7% 4.8% 3.4% 2.8% Europe Japan South Korea Middle East Taiwan Other Total Demand ,35 1,142 1,17 1,22 1,273 1,313 1,348 y-o-y % 11.% 9.5% 9.9% 7.4% 9.4% 1.1% 8.8% 1.3% 2.5% 4.3% 4.4% 3.2% 2.7% Supply ,31 1,61 1,131 1,325 1,48 1,516 Demand ,35 1,142 1,17 1,22 1,273 1,313 1,348 Market balance (notional) % surplus (deficit) -5.9% -.5% -3.3% -1.3%.9% 1.5% -4.1% -9.7% -9.3% -7.3% 4.1% 7.2% 12.4% China as a % of total demand 34.1% 41.2% 44.4% 48.6% 51.4% 66.% 59.8% 6.2% 63.7% 64.6% 64.8% 65.% 65.% Rio, BHP and Vale as % of total supply 71.5% 69.7% 7.5% 7.4% 67.6% 59.1% 67.3% 68.3% 67.8% 61.3% 63.5% 61.9% 57.9% Spot price (US$/t) (CFR China, 62% Fe) Source: Company data, Bloomberg, Platts, ABARE, Jefferies estimates page 18 of 24

19 Exhibit 3: Global Steel Supply and Demand, E million tonnes E 214E 215E Apparent steel consumption (finished steel products) China YoY change (%) 1.8% 6.8% 23.4% 6.6% 6.2% 3.6% 7.1% 4.3% 3.1% Europe (EU 27) YoY change (%) 5.9% -9.% -35.9% 25.8% 5.% -9.3% -1.5%.%.3% United States YoY change (%) -5.3% -1.8% -38.2% 29.7% 13.2% 7.% -.1% 3.4% 3.5% Japan YoY change (%) 2.8% -4.% -32.3% 2.4%.8% -.2%.3%.2%.3% Other YoY change (%) 8.4% 1.4% -13.5% 19.6% 8.2%.7% 4.6% 3.% 3.5% World 1,22 1,22 1,14 1,36 1,395 1,413 1,481 1,531 1,575 YoY change (%) 7.%.1% -6.6% 14.5% 6.9% 1.2% 4.9% 3.3% 2.9% World (exc. China) YoY change (%) 5.1% -3.5% -23.9% 22.% 7.4% -.7% 3.% 2.5% 2.8% Apparent steel consumption (crude steel equivalent) China Europe (EU 27) United States Japan Other World 1,319 1,321 1,22 1,4 1,485 1,53 1,576 1,629 1,676 Crude steel production China YoY change (%) 16.3% 4.6% 12.6% 1.7% 8.8% 3.1% 7.% 4.3% 3.1% Europe (EU 27) YoY change (%) 1.6% -5.7% -29.7% 24.% 2.8% -4.6% -2.5% -1.% -1.% United States YoY change (%) -.4% -7.% -36.5% 38.8% 7.3% 2.6%.5% 6.% 3.5% Japan YoY change (%) 3.4% -1.2% -26.3% 25.2% -1.8% -.4% 1.5% 2.% 2.% Other YoY change (%) 5.5% -1.9% -11.1% 15.% 7.6%.5% -3.9% 3.% 4.% World 1,347 1,341 1,236 1,432 1,529 1,547 1,576 1,629 1,676 YoY change (%) 7.8% -.4% -7.9% 15.8% 6.8% 1.2% 1.9% 3.3% 2.9% World (exc. China) YoY change (%) 3.5% -3.3% -2.5% 2.4% 5.2% -.5% -2.4% 2.4% 2.7% Net imports/(exports) China Europe (EU 27) United States Japan Other World Capacity Utilisation 79.% 7.7% 77.2% 78.8% 78.% 78.3% 79.7% 81.7% Source: World Steel Association, World Bank, IMF, Chinese National Bureau of Statistics, Jefferies estimates page 19 of 24

20 Exhibit 31: European Mining - Comparable Valuations Large-cap miners Current Target Upside/ P/E EV/EBITDA Company Ticker Rating Price Price Downside E 214E 215E E 214E 215E P/NPV Anglo American AAL LN Hold 1591p 165p 4% 11.2x 12.5x 1.4x 8.9x 5.4x 5.9x 5.6x 5.x.89x Antofagasta ANTO LN Hold 852p 1p 17% 9.7x 15.1x 11.7x 11.7x 4.6x 7.1x 5.7x 5.3x.93x BHP Billiton BLT LN Buy 1876p 235p 25% 12.4x 11.6x 1.5x 9.6x 6.7x 6.1x 5.6x 5.x 1.x First Quantum FQM LN Buy 1177p 14p 19% 16.1x 23.5x 17.5x 11.9x 9.4x 12.4x 1.x 6.6x.96x Glencore Xstrata GLEN LN Buy 34p 425p 25% 35.5x 19.9x 12.9x 9.5x 1.3x 1.2x 7.8x 6.1x.87x Kazakhmys KAZ LN Hold 293p 3p 3% 5.x 14.7x 15.1x 7.5x 2.3x 5.x 5.8x 4.9x.96x Rio Tinto RIO LN Buy 313p 36p 16% 9.9x 9.7x 9.2x 8.9x 6.x 5.5x 5.3x 4.8x 1.6x Vedanta VED LN Hold 1116p 135p 21% 36.6x 18.7x 13.9x 13.4x 2.9x 2.9x 2.4x 2.1x 1.1x Weighted Average 21% 16.3x 13.3x 1.9x 9.5x 7.x 6.9x 6.x 5.2x.97x Mid-cap miners Current Target Upside/ P/E EV/EBITDA Company Ticker Rating Price Price Downside E 214E 215E E 214E 215E P/NPV African Minerals AMI LN Buy 167p 3p 8% N/A N/A 1.1x N/A 18.x 5.8x 1.7x 1.2x.67x Ferrexpo FXPO LN Hold 182p 2p 1% 8.x 7.8x 8.5x 9.x 5.3x 5.1x 5.3x 5.2x.98x London Mining LOND LN Buy 116p 2p 72% N/A 9.3x 3.2x 3.6x N/A 4.6x 2.2x 1.5x.6x MMG 128 HK Hold HK$1.81 HK$2. 1% 6.4x 19.x 7.1x 4.9x 3.7x 6.4x 4.5x 3.5x.99x New World Resources NWR LN Hold 13p 7p -32% N/A N/A N/A N/A 3.9x N/A 23.9x 13.2x.89x Nordgold NORD LI Hold $1.65 $2. 21% 33.x N/A 13.1x 8.2x 3.6x N/A 4.2x 3.3x.81x Sirius Minerals SXX LN Underperform 1p 9p -12% N/A N/A N/A N/A N/A N/A N/A N/A 1.21x Weighted Average 21% 7.3x 12.3x 8.1x 5.1x 6.3x 4.9x 5.8x 4.2x.89x *Chris LaFemina is our lead analyst for the major miners. Seth Rosenfeld is our lead analyst for the European mid-cap miners. Adrian Lunt is our lead analyst for MMG **Our price targets are at premiums to our NPV estimates as our NPV estimates do not include the value of unapproved growth ***Prices as of the market close on 2 September 213 ****In weighted averages, weights are based on market capitalisations ****All estimates are based on calendar year although BHP Billiton, Vedanta and Sirius Minerals report on a fiscal year different from the calendar year *****For Glencore, we do not reduce net debt level to adjust for readily marketable inventories in our EV/EBITDA estimates ******EV/EBITDA multiples are based on attributable EBITDA estimates Source: Company Data, Bloomberg, Factset, Jefferies estimates Exhibit 32: European Steel - Comparable Valuations Current Target Upside/ P/E EV/EBITDA Company Ticker Rating Price Price Downside E 214E E 214E P/NPV P/BV ArcelorMittal MT NA Buy % 9.6x N/A N/A 23.9x 4.4x 5.7x 6.3x 5.2x.71x.46x Kloeckner & Co KCO GY Hold % 73.9x N/A N/A 36.8x 6.3x 23.6x 11.8x 7.9x 1.21x.64x Salzgitter SZG GY Hold % 7.2x N/A N/A 45.8x 2.1x 3.1x 7.6x 3.3x.74x.46x SSAB SSABA SS Hold SEK SEK 4. -8% 9.1x N/A N/A 36.x 6.7x 11.9x 12.8x 7.8x 1.37x.49x ThyssenKrupp TKA GY Buy % N/A N/A N/A 23.8x 4.4x 6.4x 7.8x 5.6x.65x 2.71x Voestalpine VOE AV Buy % 11.x 19.8x 12.9x 11.9x 5.4x 6.7x 5.6x 5.3x 1.19x 1.16x Weighted Average 16% 12.3x 19.8x 12.9x 31.8x 4.6x 6.7x 7.1x 5.4x.82x 1.16x *Seth Rosenfeld is our lead analyst for the European Steel companies **Prices as of market close on 2 September 213 ***In weighted averages, weights are based on market capitalisations ****All estimates are based on calendar year although ThyssenKrupp and Voestalpine report on a fiscal year different from the calendar year *****All EV/EBITDA multiples are based on consolidated values Source: Company Data, Bloomberg, FactSet, Jefferies estimates page 2 of 24

21 Analyst Certification I, Christopher LaFemina, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Seth Rosenfeld, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Adrian Lunt, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Ruoou Gu, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Registration of non-us analysts: Seth Rosenfeld, CFA is employed by Jefferies International Limited, a non-us affiliate of Jefferies LLC and is not registered/qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-us analysts: Adrian Lunt is employed by Jefferies Singapore Limited, a non-us affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. As is the case with all Jefferies employees, the analyst(s) responsible for the coverage of the financial instruments discussed in this report receives compensation based in part on the overall performance of the firm, including investment banking income. We seek to update our research as appropriate, but various regulations may prevent us from doing so. Aside from certain industry reports published on a periodic basis, the large majority of reports are published at irregular intervals as appropriate in the analyst's judgement. Company Specific Disclosures For Important Disclosure information on companies recommended in this report, please visit our website at Disclosures.action or call Meanings of Jefferies Ratings Buy - Describes stocks that we expect to provide a total return (price appreciation plus yield) of 15% or more within a 12-month period. Hold - Describes stocks that we expect to provide a total return (price appreciation plus yield) of plus 15% or minus 1% within a 12-month period. Underperform - Describes stocks that we expect to provide a total negative return (price appreciation plus yield) of 1% or more within a 12-month period. The expected total return (price appreciation plus yield) for Buy rated stocks with an average stock price consistently below $1 is 2% or more within a 12-month period as these companies are typically more volatile than the overall stock market. For Hold rated stocks with an average stock price consistently below $1, the expected total return (price appreciation plus yield) is plus or minus 2% within a 12-month period. For Underperform rated stocks with an average stock price consistently below $1, the expected total return (price appreciation plus yield) is minus 2% within a 12- month period. NR - The investment rating and price target have been temporarily suspended. Such suspensions are in compliance with applicable regulations and/ or Jefferies policies. CS - Coverage Suspended. Jefferies has suspended coverage of this company. NC - Not covered. Jefferies does not cover this company. Restricted - Describes issuers where, in conjunction with Jefferies engagement in certain transactions, company policy or applicable securities regulations prohibit certain types of communications, including investment recommendations. Monitor - Describes stocks whose company fundamentals and financials are being monitored, and for which no financial projections or opinions on the investment merits of the company are provided. Valuation Methodology Jefferies' methodology for assigning ratings may include the following: market capitalization, maturity, growth/value, volatility and expected total return over the next 12 months. The price targets are based on several methodologies, which may include, but are not restricted to, analyses of market risk, growth rate, revenue stream, discounted cash flow (DCF), EBITDA, EPS, cash flow (CF), free cash flow (FCF), EV/EBITDA, P/E, PE/growth, P/CF, P/FCF, premium (discount)/average group EV/EBITDA, premium (discount)/average group P/E, sum of the parts, net asset value, dividend returns, and return on equity (ROE) over the next 12 months. Conviction List Methodology 1. The aim of the conviction list is to publicise the best individual stock ideas from Jefferies Global Research 2. Only stocks with a Buy or Underperform rating are allowed to be included in the recommended list. page 21 of 24