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Vale S.A. (VALE) Q2 2019 Earnings Call Transcript

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Vale (NYSE: VALE)
Q2 2019 Earnings Call
Aug. 1, 2019, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, ladies and gentlemen. Welcome to Vale's conference call to discuss second quarter 2019 results. At this time, all participants are in a listen-only mode. Later, we'll conduct a question and answer session, and instructions will be given at that time. If you should require assistance during the call, please press *0. As a reminder, this conference is being recording, and the recording will be available on the company's website at vale.com at the investor's link. This conference call is accompanied a slide presentation, also available at the investor's link at the company's website and is transmitted via internet as well. The broadcasting via internet, both the audio and the slide changes, has a few seconds delay in relation to the audio transmitted via phone.

Before proceeding, let me mention that forward-looking statements are being made under the Safe Harbor of the Securities Litigation Reform Act of 1996. Actual performance could differ materially from that anticipated in any forward-looking comments as a result of microeconomic conditions, market risks, and other factors.

Today with us are Mr. Eduardo De Salles Bartolomeo, President and CEO; Mr. Luciano Siani Pires, CFO; Mr. Marcello Spinelli, Executive Officer for Ferrous Minerals; Mr. Mark Travers, Acting Executive Officer for Base Metals; Mr. Carlos Medeiros, Executive Officer de Segurança e Excelência Operacional; Mr. Luis Eduardo Osorio, Executive Officer For Sustainability and Institutional Relations; Mr. Alexandre Pereira, Executive Officer for Business Support; Mr. Alexandre D'Ambrosio, General Counsel; Mr. Juarez Saliba, Director of Coal, Strategy, and Mineral Exploration; and Mrs. Marina Quental, Director of People.

First, Mr. Eduardo Bartolomeo will proceed to the presentation on Vale's second quarter 2019 performance, and after that, he'll be available for questions and answers. It is now my pleasure to turn the call over to Mr. Eduardo Bartolomeo. Sir, you may now begin.

Eduardo De Salles Bartolomeo -- President and Chief Executive Officer

Thank you. Good morning, everyone. I would like to begin by expressing our respect for the families that have been suffering since the dam breach in [inaudible]. I want to thank once more our employees, the authorities, the firefighters, the civil affairs, and the volunteers -- all of the people engaged to provide support and comfort through such tragedy.

Safety, people, and reparation. These three words will continue to be our priorities and define our actions since I took on the responsibility of leading Vale. The safety of the people who work in our operations, the people from our communities, this is our obsession. This is what moved us to transform the company, and it will be the safety of our assets and our processes that we ensure the safety of the people in our operations. Please, next slide?

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Vale is totally committed to repairing damage. Over the past six months, we have made progress with countless measures to ensure the safety of the people and to repair impacts costs. A special department for recovery and development, coordinated by Marcello, has been working with agility and flexibility with the objective of alleviating the suffering of the families as well repairing the losses, interacting directly with communities in the [inaudible].

Caring for people is fundamental. Increasing the financial security of the families is only a part of that. On this front, we have divested with individual agreements with those who reach for us. At the same time, we have opened a dialogue with all the parts involved with the reparation efforts so we can build together a fair and quick solution through collective agreements. An example is the agreement established in July with the Public Minister of Labor of the State of Minas Gerais, which had the participation of workers unions and already had legal approval.

One the environmental front, we have submitted a tailings containment plan to the authorities. We have completed several restructures in the Ferro-Carvão stream water station to ensure that no more tailings are carried from the dam's breakpoint toward the Paraopeba River. For a quick repair of the dam infrastructure, a package of work is under way and includes, among other products, the maintenance and improvement of some 700 kilometers of roads in Brumadinho and region.

Lastly, we continue to give transfers to the investigations into the cause of the tragedy. The two investigations started internally, one conducted by a team of specialists and the other by an independent committee, are also ongoing. Please, next slide?

Our safety and risk management is being reinforced. We are on a journey to transform Vale into the safest and most reliable mining company in the world. The new safety and operational excellence executive office is independent from operation and reports directly to me. This structure strengthens our strategic pillar and aligns our safety and risk management governance with the best benchmarks in the world. Carlos Medeiros, with us in the call, whose solid experience in managing large transformational projects will be an important leader on this front, with focus on safety and operational excellence at Vale.

We are continuing to search for best ways to raise the safety level of our assets. We have been working to accelerate the de-characterization of nine upstream dams in Minas Gerais, and we expect to deliver the first two completely commissioned dams Fernandinho and 8B in the first half of 2020. In June, we were able to increase the safety level of the Vargem Grande dam, thus people were able to return to their homes. This is the result of a series of improvements that Vale has been implementing in the structure since January, such as lowering the reservoir water level and cleaning the drainage channels. Please, next one?

Well, we are [inaudible] advancing in our strategy. As we've said at the end of the first quarter, Vale's strategic agenda will also be one of continued focus on the three strategic pillars established in 2018: strong discipline at the location, maximizing the flight to quality in iron ore, and turnaround of base metals. We have made progresses in this quarter -- it's still a transitional quarter for Vale -- which has a premise of reducing risks in our business. With the appointment of Marcello Spinelli as Executive Director of Ferrous and with Juarez Saliba taking the leadership of the coal business, we have taken important steps toward the stabilization of production and the reliable and sustainable development of more business.

In iron ore, we have made substantial progress. As mentioned in our last call, expectation of resuming operations of the Brucutu iron ore mine was confirmed in June. We have also partially resumed dry processing production at the Vargem Grande complex, and we are having conversations with a national mining agency to restart all the dry processing operations as well.

Maximizing the flight to quality in iron ore remains one of our top priorities. Accordingly, I would like to confirm today the conclusion of Ferrous acquisition, which was announced in December of last year and recently approved by CADE, the Brazilian antitrust agency. This acquisition will increase Vale's production with high quality pellet feed at competitive costs.

Our effort to transform base metals are ongoing. In this quarter, we performed strongly at Sadbury mines in Canada. In New Caledonia, we have the biggest challenge of the base metals business. Our approach in the NC has been the [inaudible] of the management system. One example in this regard is the preventative maintenance [inaudible] other implementation. Our expectations for base metals, as previously stated, is to see the first results of this transformation starting from the fourth quarter. As for coal, we are working to stabilize production and overcome the operational challenge that have impacted our performance. We are developing our knowledge of the quality, which will allow us to be more assertive about [inaudible].

Finally, all of our actions must support our new pact with society. We want to restore society's trust in our ability to operate with safety while creating shared value, fostering sustainable economic development in the territories which we operate. We are committed to the redefinition of mining in Brazil and around the world. Please, next one?

It's important to reinforce that we are going toward great reliability. The second quarter reflects a transitional period. We had great pressure on volume and costs, which are already starting to show a positive trend for the coming quarters. A reduction of uncertainties in our business is in progress with actions to improve safety and risk management, with actions to restabilize production in all lines, and with greater predictability of expenses with Brumadinho and others. Resuming operations in Brucutu and part of the dry processing of the Vargem Grande complex is an important step to restore [inaudible] iron ore.

On the financial and operational perspectives, we've had a strong cash generation, which will help us honor our commitments to society and strengthen our balance sheet further. Luciano will give more color on this point later. We believe we are on the way to a fair and quick reparation and to the rebirth of Brumadinho in the medium term. We continue to work tirelessly to increase our safety, support the people, and repair the damage caused. I'm confident that this ongoing change will transform Vale into a safer, more sustainable, and even more human company -- a better company.

Thank all of you for your time today, and I'll now pass the word for Luciano to make the comments on the financial results.

Luciano Siani Pires -- Chief Financial Officer

Good morning and good afternoon. I will start going through the provisions. As you saw with provision about $1.2 billion of a total of $1.5 billion for environmental reparation in this quarter. The key message here is that now we have a comprehensive level of provisioning to all the scopes that we believe will be the subject of our reparation. Any changes to those provisions will come from a refinement of the numbers going forward as we get more information about how the programs will develop. So, you should not expect any additional scope to be included in the provisions.

How did we get to those $1.2 billion in environmental provisions? We based ourselves on the agreements already signed that we already know what we need to do on this topic. We based ourselves in the agreements which are under negotiation for which we already have a clear view of what the final scope will be. And we're also including compensation measures. We already have also indications about what kinds of compensation the authorities will demand for the environment. So, for example, these provisions include tailings removals, dredging of the river, recovery of fountainheads, recovery of degraded areas, and even sanitation compensation efforts, water supply security for some of the cities, water sourcing alternatives, water treatment stations, so this is very comprehensive. In total, so we have already booked in our balance sheet $5.7 billion, including not only the environmental, socioeconomical, but also the provisions for decommissioning of dams.

Relating to the business now, going to iron ore, on the volumes, just to make a simple calculation for you, of the 400 million nameplate capacity that Vale has, at one point in time we had 90 million tons stocked, plus 9 million tons of the Córrego do Feijão mine in Brumadinho, which will never come back. So, therefore, our production capacity bottoms at 300 million tons. Now we have about 30 million back of Brucutu and 12 million of dry processing in Vargem Grande. So, therefore, as we speak, we have a total production capacity between 340 million and 345 million tons annualized, and additional comebacks of operations will add to that number.

In terms of costs, as you saw, there was an important increase in cost from the first to the second quarter. Three main drivers for that. The [inaudible] costs, which we underestimated when we spoke to you on the last call, but this is completely normalized now. The line of vessels is back to normal levels. There are the iron ore prices, which impact the purchase of feed from third parties, and that's good news, but it has impact on costs.

And there is the cost carryovers because of the 45-60 days which takes from production costs to flow through inventories and then to be sold. If you take this, you have approximately $160 million of access [inaudible] and if you add on top of that the $351 million of stoppage and other expenses related to Brumadinho, of which $225 million -- and you'll find all those numbers in the release -- relates to stoppage expenses themselves, and $126 million to logistics extraordinary expenses, when you add all of this, you get to approximately $500 million of ongoing, recurring effect on the business related to the stoppages and to the consequences of the Brumadinho dam bridge.

So, what we're telling you is we have addressed the reparation costs fully to our best knowledge on the balance sheet; however, we had $500 million of recurring business impact, of which we expect a reduction going forward. What reduction? We expect $2.50 return reduction on C1 because of the elimination of the merge effect, cost dilutions, and the reduction of the carryover effects on cost, and we expect $1.50 dollars per dollar of reduction in expenses related to the comeback of [inaudible], which naturally reduced the stoppage expenses. When you add those $2.50 plus $1.50, multiplied by production, we expect of those $500 million recurring impact on the iron ore business, $300 million will be out of the financial statement next quarter, so that's the size of the improvement we're expecting going forward.

Another topic important in iron ore is freight. You saw the very steep increase in spot rates in the month of July, reaching $27 per town from Brazil to China. This will not meaningfully impact Vale on the third quarter. We expect a very small marginal increase in our average freight rates. The main reason for this is because of the smaller production, our exposure to the support market today is minimal. On the fourth quarter, if you want to discuss, we can do later. We will start to see some effects of the new IMO regulations, which will then be mitigated over 2020 and 2021. But the freight rates, on a relative basis, the freight rates for Vale will remain very competitive, even in this environment of increased freight rates.

Talking about the other businesses just very briefly, I would like to stress the very strong performance for copper. We will reach our guidance this year. And why is this important? Because part of the copper production comes from the Canadian mines. The Canadian mines are performing very well. The mines, the mill, the smelter, and you're not seeing this in the nickel numbers because of specific problems we had with the refineries. But the copper production doesn't flow through the refineries, so it is proof that with the turnaround of base metals starting to bear fruit in Canada that we are increased by more than 30% the copper production from Ontario this year, and we're gonna reach our guidance. It's gonna be very strong Q3 and Q4.

In nickel, Q3 will post an improvement, although because of the scheduled mine maintenances, not as strong as what we'll see in Q4, which will then be very strong. Do not expect improvements yet in New Caledonia in the second half. We may discuss this in the Q&A.

You saw a little bit of increase in financing costs because of the additional debt that we took over to buffer up our cash resources in the first quarter. These additional debt has been repaid, so financing costs will come down over the next quarters. When you look at net income, we had also non-cash impacts that go beyond Brumadinho. Most importantly, the Germano dam, which is a dam at Samarco will be decommissioned as well. We have an estimate of over $500 million to this decommissioning, so Vale's share was provision, and we also had an update on the indemnification expenses through the Renova Foundation in Samarco and Vale's share, $383 million, was also provision. Investments came in low, but they will recover in the second half, so we still expect to reach over $4 billion in investments this year. And in summary, you saw the very strong cash flow numbers, which will naturally improve in Q3 and Q4.

...

So, in summary, what we expect for the second half of the year is marginal variations in the provisionings on the balance sheet related to Brumadinho, decrease in cost, and higher production volumes with the recovery of the operations, some already announced and some that we expect.

Questions and Answers:

Operator

Excuse me. I'd like to make a correction. The name of the Executive Officer of Safety and Operational Excellence is Carlos Medeiros and not Marcos, as I said before.

We will now begin the question and answer session. If you have a question, please press *1 on your touch-tone phone now. If at any time, you would like to remove yourself from the queue, press *2. Please restrict to two question at a time.

The first question comes from Carlos De Alba, Morgan Stanley.

Carlos De Alba -- Morgan Stanley -- Analyst

Good afternoon, gentlemen. First question would be on what are the next steps on concluding the agreement or the framework related to the Brumadinho event? When do you expect or when can we expect perhaps to have the sign-off of the prosecutors and the other authorities in Brazil so that the company and the market can close this tragic event and start focusing on actual reparations in the litigations, which I understand you have already started? And my second question is regarding the restart of the 20 million dry operations, that I've seen in the slide that you presented, what I read in the release is that by year-end, they should be restarting, but does that mean that only at the beginning of next year, they will start producing, or can we expect a gradual ramp-up throughout the second half of the year, and therefore, by the beginning of next year, the 20 million run rate will be already achieved? Thank you for your clarifications.

Luciano Siani Pires -- Chief Financial Officer

Carlos, [inaudible] indicates that Samarco, where you had one single agreement to address all the topics of the civil lawsuits, we've been addressing specific matters of the civil lawsuit one by one, so we have already 15 agreements which have been already settled, which means that the scope of the remaining agreements to be signed keeps reducing. There will come a point when the authorities feel that all the relevant topics of the lawsuits have been addressed. Yes, there can be a suspension of those lawsuits, and through the progress that we've been making, we expect this to happen until the end of the year.

But what is important to notice is that you talked about closing this tragic event. From a perspective of estimating the total financial impact, given all the negotiations that are ongoing, we expect this to be a quarter of closure. But from a legal standpoint, obviously, we need to see the agreements be signed one by one. One concrete example of that is that in the first quarter, we made a provision for the reparation of our employees and of the families of the deceased employees, and we finalized from a legal perspective the agreements this quarter, and we actually eliminated the civil lawsuit, and the difference between the final agreement and the original provision was small.

So, that's the dynamics that we expect going forward. There will be perhaps some differences in the actual numbers and the provision numbers, up or down, but from a scoping perspective, everything that we know and that's on the table being negotiated with the authorities is being taken care of, and we have an expectation that until the [inaudible] perhaps we will address all the issues from a formal perspective.

Marcello Spinelli -- Executive Officer for Ferrous Minerals

Carlos, this is Marcello Spinelli. Thank you for your question. It's a pleasure to talk to you. It's my first time here. Regarding the production, we already have our one-third that we are already talking about the dry operation, just reinforce already have the return of the peak of production in Vargem Grande, and just to answer, that's a gradual return. So, just to have in your mind what it's based on, we need to prove and talk to the National Mining Agency that we don't have any impact in the dams, so that's what we call a seasonal impact, so we need to check with engineer tests to guarantee that we can return step-by-step the operations. So, we are committed to have this return in the next six months, and just to reinforce what you said, we expect to have the run rate at operation in the next year but to recover partially the operations during the next semester.

Operator

The next question comes from Timna Tanners, Bank of America Merrill Lynch.

Timna Tanners -- Bank of America Merrill Lynch -- Analyst

Hey, good morning and thanks for all the great details. I wanted to take a step back and ask if you could give us some detail on the expansion plans in the northern system and remind us about your progress or your projections there timing-wise and also the necessary infrastructure involved to get to the increased production targets? My second question was really hoping for more detail on nickel, also a bit high level. So, I know in the past, you've talked about potentially consolidating or divesting some of the underperforming assets, but there's also been some headlines about some potential big investments there, so I was just wondering if you can clarify how you're thinking about that business over the medium term? Thanks very much.

Eduardo De Salles Bartolomeo -- President and Chief Executive Officer

Timna, thanks for the question. I think the process undergoing there is an operational turnaround. We need to structure the business to be able to whatever route we can. So, I think as Luciano mentioned, we've been doing progress very well in Canada, and we're struggling with the New Caledonia, as we already said. So, for that sense, we keep our strategy to catch the upside of the electric vehicles for the nickel. And as I think some of [inaudible] that have been made in Indonesia are around joint ventures that will be created, internally funded by PTVI, by the way. And they'll be self-funded from PTVI.

So, basically, nickel is focused on transforming the business, on transforming the operation, having the assets on the condition that they're supposed be. Most importantly, as I already [inaudible] in GNC that is really underperforming. So, I think nickel is up to capture the upside from electric vehicles. And I think the expanse plans for the north, I'll pass the word for Spinelli.

Marcello Spinelli -- Executive Officer for Ferrous Minerals

Eduardo, before we go on, perhaps you should comment on Indonesia because that was perhaps the headlines that were mentioned by Timna.

Eduardo De Salles Bartolomeo -- President and Chief Executive Officer

I mentioned Indonesia. I think it was [inaudible] when we had the problem on the phone. Those headlines, they related to the investments that has to be done in Indonesia for the resource, but they will do on a joint venture basis and fundamentally through the financing of the PTVI, so it's gonna be an active finance, the exposure of risk and finances being discussed. It's not been approved, by the way, so it's just a matter of the development of the resources in Indonesia.

Marcello Spinelli -- Executive Officer for Ferrous Minerals

Hi, Timna, thank you for the questions. It's a pleasure to talk to you. Let's divide this in three steps. So, first one is about the ramp-up of the S11D, it is going really well. We're in a run rate this quarter of 230 million tons. We expect to expand the system, the northern system, to the 240 million tons on the second half of 2022, and we're already planning. We don't have yet the conclude the product. We are planning to expand the S11D to 150 million tons, so we're gonna have further information about this expansion when we get the final details of the new year.

Operator

The next question comes from Chris Terry, Deutsche Bank.

Chris Terry -- Deutsche Bank -- Lead Equity Research Analyst

Hi, Eduardo and Luciano. Thanks for taking my questions. The first one is on the pellet market. You have got this year at around a 45 million ton level. Does this include the acquisition of the 4 million tons? I don't think it does. But can you just talk about your pathway back to 60 million tons and above and also just some thoughts on how Samarco might fit into your medium-term pellet guidance? Thank you.

Luciano Siani Pires -- Chief Financial Officer

Thank you, Chris, for your question. Regarding pellet market, well, we have the constraints in production. We now have the number of 45 million tons in production this year. It depends on the pellet feed production that we are out of product in the southern system. So, regarding production today, we are full in Tubarão and the north system, and also [inaudible]. To recover about 11 million to 15 million tons of production in the southern system, we need to recover the production of pellet feed that we still have to wait for the return of the wet production in the southern system. So, gradually, we're going to return this production, in this case, in the more mid to long-term view in almost two year. We can feed these plants, Fábrica and also Vargem Grande, using some product from [inaudible], but we still don't have the total capacity to return this plant. So, we plan to recover this in the few months, but we need to guarantee the pellet feed production to have it.

With regards to Samarco, the expected restart for Samarco is second half of 2020, but Samarco will restart with only a third of its capacity, so 10 million tons. And still, this third will be subject to a ramp-up. To add a second concentrator to Samarco depends on additional work toward tailing systems. Samarco had a plan to restart a second concentrator soon thereafter the first concentrator, but these plans were jeopardized because of the new regulations following Brumadinho. We're currently working on adjustments to its business plan to see when the second concentrator should restart. And the third concentrator, even in the original business plans, would be dependent on the permitting of a brand-new structure, be it probably a new [inaudible], which becomes even more of a constraint in the much medium to long-term future. So, do not expect Samarco to make a meaningful contribution to [inaudible]markets in the short term.

Operator

Our next question comes from Amos Fletcher, Barclays.

Amos Fletcher -- Barclays -- Director, Equity Research

Good afternoon, gentlemen. Just one question really. I just wanted to ask about the 20 million tons of dry processing you're potentially gonna bring back. I just wanted to ask, given how quickly the Vargem Grande capacity was restarted, can we expect for the next 20 million tons of dry processing could restart sooner than the year end? And could you also give some clarity on how that dry processing output would influence your product mix? Thank you.

Eduardo De Salles Bartolomeo -- President and Chief Executive Officer

As I told, it depends on negotiation and also studies in engineering design to test actually the impact of the regular production, the dry production, in the dams. Actually, we need to do these side by side with the National Agency, so they have a line to progress this analysis and return step by step. So, the first one was Pico in the Vargem Grande production, so you're waiting to recover Abóboras, [inaudible], Alegria, Fábrica, so step by step. We are expecting to do this in the next six months. So, the recovery is gradual, and the rating the first quarter next year to have a run rate production of the other 20 million tons.

Regarding product mix, it is important to say this product will feed our BRBF, the Brazilian Blend Fines, that we blend with the Carajás fines, so it's a very important product to guarantee that we have the total use of the Carajás and [inaudible] to the market. So, this will feed the BRBF.

Luciano Siani Pires -- Chief Financial Officer

Carajás fines cannot be mixed with all the lower-quality ores to make BRBF because the specific product from the south, the dry processing from Vargem Grande, for example, has very low aluminum, and a key feature of the BRBF is low aluminum. So, whenever you bring Vargem Grande back, for example, you do more BRBF, which you couldn't do otherwise.

Operator

The next question comes from Grant Sporre, Macquarie.

Grant Sporre -- Macquarie -- Head of European Mining Research

Hi. Good afternoon, gentlemen. Thanks for hosting the call. Just two questions on my part, just a small technical one. [Inaudible] mine, which system will those tons be reported under? So, very simple question. And then, the second one is is it too soon to be restoring the [inaudible] policy, just given that you now have more clarity on provisions? Your debt has come down and the cash generation in Q2 was very strong. Thank you.

Marcello Spinelli -- Executive Officer for Ferrous Minerals

Hello, Grant. It's a pleasure to talk to you. Well, the ferrous production will be connected to the south complex. So, we can use to feed our plants of Fábrica, the pelletization abrasion. We still have contracts in place that we need to finish, so we're going to keep this contract until the end of the year, have a [inaudible] of this contract. So, after this end of the year, we can use the product to feed the production of the south system.

Eduardo De Salles Bartolomeo -- President and Chief Executive Officer

Grant, thanks for the questions. Just to be very clear, we're not discussing dividends now. We're focused totally on the reparation and restoring our risk profile of the company. Thank you for your question.

Operator

The next question comes from Tyler Broda, RBC.

Tyler Broda -- RBC Capital Markets -- Director, Global Mining Research

Great. Thanks very much for the call today, everybody. My question, I was actually just gonna ask a similar question to Grant, but I guess while I'm on the line, have you seen with any of the following Chinese steel margins, have you seen any change in the behavior of your customers yet?

Luciano Siani Pires -- Chief Financial Officer

Tyler, thank you for your question. The margins of the steel market in China depends on the production to keep the strength of the market there. So, we really believe in three components that are still pushing the sales and the production. First one is about the property market. We think that's slowing down but not really something that we need to be worried [inaudible] is not reinforcing [inaudible] but on the other hand, we have the manufacturing and the production of other investment that can be covered. So, considering this part of the balance of supply and demand, on the supply, we still have the recovery of Vale in their other majors [inaudible] majors, but we still have a gap in the stocks. So, just a gradual process to rebalance the demand and the supply. So, the price is still high. They're pressured by the raw materials costs, and we still see a constraint in the narrow margin for this market.

Eduardo De Salles Bartolomeo -- President and Chief Executive Officer

Just for coming back to Grant's question -- sorry, Tyler's question about dividends, being very clear that we have other options to do -- Luciano will explore a little bit where our mines are in the short term. As I mentioned, focus on repairing. In due time, we've come back to discuss that, but there are other options that we can discuss as well.

Luciano Siani Pires -- Chief Financial Officer

We are very mindful of the needs of our shareholders, and no one more than us would like to get back to normal, so we can resume dividend distribution. In the meantime, the way we're thinking about the balance sheet is you saw that with the releases of funds, our pro forma net debt is about $8 billion today. There's another $1.8 billion of leases on the balance sheet, IFRS leases. And those $5.7 billion that were provisioned, they will need to be disbursed at some point in time, so once should think perhaps of these [inaudible] also as a liability when you think about capital structure. But it's also true that the cash flow generation was strong in the second quarter. It will be even stronger in the third and fourth quarter. So, if you think about our $10 billion target net debt when you put this all together, we're not there yet.

But on the other hand, once the cash starts coming in, there is no alternative use for it in projects or whatever, rather than manage the balance sheet and perhaps make a nest egg for future distributions. In terms of using a balance sheet, we can, yes, address part of those leases, which today consume financial expenses, and there are other liabilities on the balance sheet. For example, minorities still have shares in our NBR, one of our subsidiaries. There are others that may be addressed on the second half. If eventually, the balance sheet becomes undelivered, this will be fixed when, let's say, the social license to pay dividends comes back. We will likely relever the balance sheet in order to do the proper distributions going forward. But this is I'd say a medium-term concern of management. Shorter term, as Eduardo underscored, we are not discussing because we are very mindful of what the homework we need to do first.

Operator

The next question comes from Alex Hacking, Citi.

Alex Hacking -- Citi -- Equity Research Analyst

Hi, and thank you for the call. I have two questions related to iron ore. First question, could you discuss your inventory strategy in the second half of this year? And then, the second question, once Vale is back to 400 million tons in two or three years' time, should we think about your cost structure being back where it was historically, or will there be some long-term effects from Brumadinho in terms of operating costs? Thank you.

Marcello Spinelli -- Executive Officer for Ferrous Minerals

Hello, Alex. Thank you for your question. This is Spinelli here. Talking about inventory, the first half, we used about 6 million tons of our stocks to guarantee the sales and the -- actually, it was a trend in the market. In China, we could see a decrease of 30 million tons. So, what we see is the supply and demand is more in the trend to recover balance. We don't see for the market this fast recovery of the inventory, but it's a mid-term process to recover the inventory. So, that's what we expect with the decrease of the inventories in the whole China for the whole suppliers.

Luciano Siani Pires -- Chief Financial Officer

For all practical purposes, we believe the cost structure will return to the 2018 levels. From a strategic perspective, perhaps, obviously, Vale will spend more, for example, on dry stacking. We will accelerate our plans through new steel to do dry concentration, but the impacts on the cost structure will be marginal and longer term and more than compensated by the ongoing cost reduction initiatives with digital transformation, operational [inaudible], and cost cutting. Just a note for you, in May of this year, so two months ago, S11D reached the nameplate business case cost performance of less than $8 per ton, so we reached $7.70 dollars per ton at S11D. As the S11D proportion, the overall of Valle increases, and you're not seeing it today because of all that noise around the cost structure. Structurally, you could have a lower cost structure because of the larger share of S11D.

Operator

The next question comes from Sergei Donskoy, Societe Generale

Sergey Donskoy -- Societe Generale -- Senior Analyst

Thank you very much. I have one question [inaudible] if it will be a simplistic one. Just trying to understand your production performance in iron ore and put this into context of your guidance. In Q2, iron ore production outside of the northern system was in annualized terms, roughly 90 million tons. In Q2 last year, it was around 200 million tons, and the average of the last 3-4 years was also around 200 million tons, so we're talking about roughly a decline [inaudible] about 110 million tons. How can this be reconciled with 93 million tons, which as you show in the presentation was the effect of those stoppages? What was the additional impact in Q2 that led to stronger decline? Thank you.

Luciano Siani Pires -- Chief Financial Officer

Well, that's a hard question. I would guess that we are talking about typical variations, and we may have had a weaker quarter in some operations in the south, but actually, when we talk about 90 million, it's 93 million, that this is the loss of production. Every operation has some long-term trends toward production. Sometimes, for example, the production within Mariana has been coming down slightly over the years. Production EBITDA had a great jump in '15 and '16 and was coming down recently. But you can be pretty sure that the bottom of the production capacity of Vale was 300 million tons when we had 93 million tons stopped plus 9 million tons. That's a good point. One piece which is missing is the 9 million tons of Brumadinho itself, which will never come back.

So, when we say that we have 93 million tons stopped, the actual total loss was 102 million tons, but it's the 93 million tons which may eventually come back plus 9 million tons that will never return, so that accounts to half of your difference. I'm pretty sure that the other half is small variations among the different operations. And as a consequence, which is implicit in your reasoning, is that the northern system is increasing and compensating part of this larger loss in the south, so today, the total, when we talk about 400 million tons of capacity within Vale, people should think more of 220 million to 230 million tons in the north, and 180 million to 170 million tons in the south. So, that's what we need to do is to try to recover this 180 million tons production in the south and the southeast.

Operator

Our next question comes from Alfonso Salazar, Scotiabank.

Alfonso Salazar -- Scotiabank -- Director

Good morning, gentlemen, and thank you for the call. I have two questions. The first one is regarding the [inaudible]. Outside China, because what we really have seen the first half of the year has been a strong [inaudible] production in China but not so in the rest of the world. So, you can make comment on that. And also, keep in mind that there is an increase on ferrous scrap use in the past year, so how do you see that evolving in time? The second question is on the New Pact with Society that is one of your new strategies. If you can comment on something specific on the timing, how do you plan to implement that [inaudible] and the investors need to understand that Vale is working under [inaudible] standards from now on, so if you can give some details on this as well. Thank you.

Marcello Spinelli -- Executive Officer for Ferrous Minerals

Thank you for your questions. This is Spinelli speaking here. As I said, China, there's a lot of pressure, and the demand is actually making the price higher. We expect a 5% increase in the production and the demand there. Ex-China, we are confident in the lower growth. It's 1.5%. We have some pressures in some markets regarding the problem of the high price, specific for China, but they are the price setter of the market, so we have in Europe some productions that are slower with slower growth than we expected in the beginning of the year, but they are keeping the growth in 1.5. That's what we are working on in our forecast.

Eduardo De Salles Bartolomeo -- President and Chief Executive Officer

Alfonso, thanks for your question. I'll try to be brief. This pact starts with fundamental things that society has to trust that we can operate safely. That is a broader discussion. It has to be done with society, it has to be done with direct layers, with the associations. In Brazil, we are talking with [inaudible] instance on that sense, and in the world, we're talking to ICMM, as you know, is developing new standards for mining. So, first of all, safety is the key issue here.

Second, we have to expand development to where we operate. Brumadinho is a good example because you stop the mines, suddenly, you have three-star economic development there, or you should prepare when that happens in the sense of EBITDA is something that's coming, so you need to prepare the new phase after mining is done. So, developing the territory is a very element in that.

And thirdly, we are going to start discussing a lot. It has to do even with the scrap that you just mentioned. We need to create an environmental benefit for society. As miners, we have to look at the chain. We have to go beyond Scope 1 and 2. We have to look at Scope 3. So, the redefining our carbon footprint, we announced last year in Vale Day our GDS -- ODS, sorry. I'm translating the English -- ODS with [inaudible], and we're going to expand that. We're gonna come even more aggressive on our strategic plan.

So, in sum, it's operated safe, have the territory, develop the territory, and build the sustainable future for society. I hope I answered you well. Thanks for your question.

Operator

The next question comes from Peter Grechenko [inaudible], Barclays.

Peter Grechenko -- Barclays -- Analyst

Hi, good morning and thanks for taking my question. I wanted to follow up a little bit more on the debt reduction plan. Can you maybe be a little more specific in what you're contemplating with respect to debt reductions? Do you think the company could resume tendering for the bonds as you did in the past, or you're more targeting the loans and bank that? If you considering tendering, then maybe you can provide some color on how you're thinking on that, any particular trench or reduction across the curve? I mean, any details would be helpful.

Luciano Siani Pires -- Chief Financial Officer

Peter, this level of detail we cannot disclose, but if you just do the math, it's very clear that we will need to attack everything at the same time. So, it's not that we have so many alternatives. What I indicated in my previous analysis of the balance sheet is that also beyond loans and borrowings, there are other liabilities that we may present opportunities for balance sheet optimization. So, leases were an example, minorities was another example, and there are others. So, that will be the main use of funds for the cash surplus until we resume paying dividends.

Operator

This concludes today's question and answer session. Mr. Eduardo Bartolomeo, at this time, you may proceed with your closing statements.

Eduardo De Salles Bartolomeo -- President and Chief Executive Officer

Thank you for your participation and questions. I would just like to reinforce, as we've been doing the call, it was a transition quarter. We are really moving toward a greater reliability. We are improving our safety, our risk management. We are resuming production. We increased the predictability of the [inaudible], so that's very well said, but I just want to conclude my speech with the three words that are guiding our work inside Vale: reparation, safety, and people. Once again, thank you for your participation. Have a good day.

...

Operator

That does conclude Vale's conference for today. Thank you very much for your participation. You may not disconnect.

Duration: 59 minutes

Call participants:

Eduardo De Salles Bartolomeo -- President and Chief Executive Officer

Luciano Siani Pires -- Chief Financial Officer

Marcello Spinelli -- Executive Officer for Ferrous Minerals

Mark Travers -- Acting Executive Officer for Base Metals

Carlos Medeiros -- Executive Officer of Safety and Operational Excellence

Luis Eduardo Osorio -- Executive Officer For Sustainability and Institutional Relations

Alexandre Pereira -- Executive Officer for Business Support

Alexandre D'Ambrosio -- General Counsel

Juarez Saliba -- Director of Coal, Strategy, and Mineral Exploration

Marina Quental -- Director of People

Carlos De Alba -- Morgan Stanley -- Analyst

Timna Tanners -- Bank of America Merrill Lynch -- Analyst

Chris Terry -- Deutsche Bank -- Lead Equity Research Analyst

Amos Fletcher -- Barclays -- Director, Equity Research

Grant Sporre -- Macquarie -- Head of European Mining Research

Tyler Broda -- RBC Capital Markets -- Director, Global Mining Research

Alex Hacking -- Citi -- Equity Research Analyst

Sergey Donskoy -- Societe Generale -- Senior Analyst

Alfonso Salazar -- Scotiabank -- Director

Peter Grechenko -- Barclays -- Analyst

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