By Masam Abbas - January 17, 2013 | Tickers: BHP, CLF, VALE, GS, RIO |

Masam is a member of The Motley Fool Blog Network -- entries represent the personal opinions of our bloggers and are not formally edited.

The recent comments regarding the iron ore prices have left Vale’s (NYSE: VALE) investors in bewilderment. Some ‘experts’ have stuck up their heads and said that iron ore prices are going to crash to the level from which they rallied last September. Others, like, the Deutsche Bank believe that the iron ore prices will rocket to $170/ton. How should Vale's investors tackle this situation? And can Vale offer them anything else beyond the iron ore recovery?

Understanding iron ore Prices

Iron ore prices have rallied around 80% since September, recently crossing the $150/ton mark.

However, this rally, in no way should be considered as a recovery in the global economy, especially the Chinese economy, which accounts for around 70% of total iron ore consumption in the world. Iron ore demand is extremely seasonal, as the following chart shows:

The demand is mostly high in the first quarter of the calendar year due to the seasonal restocking cycle at the Chinese ports.

However, what needs to be asked is how much of the rally in the iron ore prices has been factored in Vale’s price:

The chart shows that Vale has seen the largest capital appreciation among its peers, since September, after Rio Tinto (NYSE: RIO). Despite displaying such large gains, I still believe there is room for more capital appreciation. I say so because the last time such a restocking took place at the Chinese steel mills, the iron ore players posted much larger gains:

It is amazing to see how each player posted more than 30% capital appreciation, the last time such a rally took place. And look at the gain posted by Cliffs Natural Resources (NYSE: CLF)! This comparison may sound a bit crude, but this rally that occurred two years definitely gives us a hint that there are some more gains to come in the next couple of weeks.

In fact, Goldman Sachs (NYSE: GS) believes that fundamentals are looking much stronger this time, which may not allow the iron ore prices to fall much (after the seasonal demand goes down). They believe that iron ore price may not fall below $145/ton, though interestingly, Vale’s investors are pricing iron ore at $122/ton. (Therefore, the rally in iron ore prices has not yet been priced-in the stock.)

Stock-specific factors

The management’s renewed focus on improving the company’ operational efficiency should lead to cost and expense reductions, lower working capital needs, and asset divestitures that could positively impact 1Q13 earnings and provide support for further stock outperformance.

Vale’s recent outperformance relative to its diversified peers has been justified, in my view, given a higher exposure to iron ore (accounts for 58% of its revenues) and lower multiples. It is also to be noted that the stock is still trading at a large discount to peers on an EV/EBITDA and P/E basis which makes me believe that there are some more gains to come in the near-future:

*2013 multiples

BHP Billiton (NYSE: BHP) has the most expensive valuations in the iron ore group.

Conclusion

I expect the discount to narrow as investors gain more confidence in the iron ore price cycle, and as the company delivers cost/expense/working capital reductions.