1 Scenario That Could Cause Cliffs Natural Resources to Rally

Macroeconomic factors can affect stock prices significantly. Quantitative easing, for example, initiated the present U.S. bull market. 

Chinese economic conditions in particular are a strong determinant in commodity producer share prices since China consumes nearly half of many of the world's commodities and 60% of the world's iron ore. If China sneezes, commodity companies catch a cold.

And Cliffs Natural Resources  has definitely come down with a cold. After minting profits during China's rise from 2004-2007, Cliffs Natural Resources is now bleeding money as China's economy slows due to a deflating credit bubble. Because of China's halting economy (in addition to low-cost Australian iron ore supply just coming online), iron ore prices are significantly lower than before. Iron ore now trades below $100/ton versus $150/ton in February 2013. 

While lower iron ore prices have caused all iron ore producers including BHP Billiton Ltd.  and Rio Tinto  to suffer, low iron ore prices have affected more levered and less diversified companies like Cliffs Natural Resources the most.  Year to date, Cliffs Natural Resources' stock has fallen over 40% in contrast to Rio Tinto's 6% fall and BHP Billiton's flat performance.

So what can cause things to turn around?

Well, it all depends on China. If the country does another round of stimulus like it did in 2008, shares of Cliffs Natural Resources would most likely turn around in a major way.

Because its production costs are so close to the current price of iron ore, Cliffs Natural Resources is currently a marginal producer. As a marginal producer, Cliffs Natural Resources suffers the most when iron ore prices fall. The inverse is also true, however; if iron ore prices rise, Cliffs Natural Resources would benefit the most. 

A meaningful Chinese stimulus would make Cliffs Natural Resources profitable and cash flow positive again. It would also allow the company to divest assets at a higher market price. Given the huge short interest in the company's stock, it would most likely trigger a significant rally as well.

The problem, however, is that the Chinese leadership is unlikely to do any meaningful stimulus anytime soon. Given the perilous Chinese credit conditions, it is extremely risky for China to try to kick the can down the road. If China does another significant round of stimulus, it risks experiencing a lost decade like Japan did after 1989. In fact, China's President Xi JinPing has said that China will have to adjust to a new normal of slower growth, implying that China will not do any meaningful stimulus. 

In the absence of meaningful Chinese stimulus, the best that Cliffs Natural Resources can do is to play defense by cutting costs. The company has already cut capital expenditures by over $500 million from last year. It may also have to cut its dividend in a further effort to preserve cash. 

Short of taking Casablanca Capital up on its proposal to split the entire company into two, there is only so much that Cliffs Natural Resources can do. The company has to wait until enough supply leaves or enough demand enters. Until China announces a meaningful stimulus policy or its economy turns around, shares of Cliffs Natural Resources will likely remain pressured. 

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The article 1 Scenario That Could Cause Cliffs Natural Resources to Rally originally appeared on Fool.com.

Jay Yao has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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