Cliffs Natural Resources recently announced a $100 million reduction to its capital expenditure estimate for 2014. This reduction is in addition to the previously announced 55%, or $460 million decrease in estimated capital expenditure for 2014, as compared to 2013. The full-year capital expenditure range for 2014 is now expected to be $275-$325 million, approximately 65% lower year over year. Around 75% of the planned reductions in capital expenditure will impact the company’s high-cost Eastern Canadian Iron Ore operations and North American Coal operations. The company believes that the reduced capital expenditure estimate is enough to support its full-year production volume and cash cost expectations as well as safety and environmental obligations.

The reductions in capital expenditure are a part of Cliffs’ efforts to lower costs in order to remain competitive in an environment of low iron ore and metallurgical coal prices. The company had reaffirmed its commitment to disciplined capital allocation in its Q1 2014 earnings conference call.

Iron Ore And Coal Prices

Iron ore is the chief raw material for the steel industry. Thus, demand for iron ore by the steel industry plays a major role in determining iron ore prices. Though a majority of Cliffs’ iron ore sales are to the North American steel industry, sales agreements are benchmarked to international iron ore prices. International iron ore prices are largely determined by Chinese demand since China is the largest consumer of iron ore in the world. It accounts for more than 60% of the seaborne iron ore trade. Flagging demand for iron ore from China in the wake of an economic slowdown has put downward pressure on iron ore prices. According to data from China’s National Bureau of Statistics, growth in investment, factory output and retail sales has slowed to multi-year lows in the first two months of the year. A Chinese government crackdown on polluting steel plants has forced many of them to shut down. In addition, tightening of credit by Chinese banks to steel plants that are not performing well will affect their ability to purchase iron ore and thus the overall demand for it. This has resulted in an inventory build-up at Chinese ports which will further curtail imports. Further, the Chinese leadership has proposed structural reforms of the economy, shifting the emphasis from investment and export driven growth to services and consumption led growth. Such a transformation of the Chinese economy may negatively impact Chinese demand for iron ore in the long run.

On the supply side, expansion in production by majors such as Rio Tinto and BHP Billiton has created an oversupply situation. A combination of these factors is likely to result in lower iron ore prices in the near term. Lower iron ore prices will impact Cliffs much more than the major mining companies due to the company’s higher cost of production of around $70 per ton, as compared to less than $50 per ton for Rio Tinto and BHP.

Iron ore spot prices stood at $100.56 per dry metric ton (dmt) at the end of May 2014, about 18.9% lower than a year ago. The outlook on iron ore prices remains bleak in the near term, in view of the oversupply situation.

China is also the largest consumer of metallurgical coal in the world. There has been falling demand for the commodity by the Chinese steelmaking industry along with lower demand from other major consumers such as Japan and the EU. Falling demand coupled with an oversupply situation due to expansion in production by major mining companies has resulted in plummeting coal prices. This will have a negative impact on Cliffs’ North American coal business which primarily sells metallurgical coal, whose prices are linked to prices of Australian metallurgical coal.

Cliffs’ Response

In order to remain competitive in a subdued iron ore pricing environment, Cliffs has cut costs as well as adopted a strategy of disciplined capital allocation. The company has idled some of its higher cost assets in view of low iron ore prices. The Point Noire pellet plant was idled in 2013 and the Wabush mine was idled at the end of Q1 2014. Further, the company suspended the planned Phase 2 expansion at its Bloom Lake operations. The company also recently announced the sale of an exploration camp which is a part of its suspended Chromite project in Ontario. These are attempts to free up capital and deploy it into projects that generate greater value for the company.

There may be more reductions in capital expenditure if the iron ore pricing environment deteriorates further. The company has stated that it may idle Phase 1 operations at its Bloom Lake mine if prices fall further. Thus, Cliffs is sticking to its strategy of focusing on its lower cost assets that generate greater value for the company and its shareholders.