Are Iron Ore Stocks About to Face Another Downturn?

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Iron ore prices have recovered about 40% since a swoon in late 2012, helping shares of ore miners like BHP Billiton (NYSE: BHP  ) , Rio Tinto  (NYSE: RIO  ) , and Cliffs Natural Resources (NYSE: CLF  ) bounce off recent lows. But the rebound might be short lived. Certain supply and demand factors suggest another downturn might be approaching.

Good results help miners boost global supplies
Supply and demand ultimately determine the price of a commodity. Too much supply or too little demand can weaken the price, causing a producer's earnings -- and share price -- to suffer. For iron ore, supplies look ready to proliferate as production ramps up.

BHP Billiton, the world's biggest miner, has benefited from iron ore's recent resurgence. It reported fiscal first-half profits rose 31% year over year. Expecting continued improvement, BHP grew its global iron ore production by 19%.

Though optimistic, the company is aware of the possibility of excess production. Management admits that the supply of iron ore will likely exceed demand later this year. Regardless, the miner has started increasing deliveries from its Western Australian operations, where it attained record production over the last six months.

Rio Tinto, another global mining leader, tells a similar story. It also delivered strong financial results in 2013, with adjusted earnings up 10% year over year; the gain came mostly from iron ore. Focusing on the lucrative product, Rio's production jumped 5% year over year for all of 2013 and 7% in the latest quarter.

The miner's large Simandou iron ore deposit in Guinea is expected to provide future growth. The site, anticipated to be the largest integrated iron ore infrastructure project and mine ever developed in Africa, hopes to deliver 95 million tons per year at full capacity, a 30% boost to Rio's total 2013 production.

Management appears comfortable with this large addition to supply. Company executives believe they will sell all they can produce, noting that Chinese steel mills need Rio's high-quality output to help cut the that nation's pollution.

Cliffs Natural Resources, a smaller industry participant, appears equally sanguine about future demand. Improved 2013 results, where adjusted net income climbed more than 36% year over year, has boosted confidence. A 10% increase in global ore pricing in the latest quarter and solid demand from the U.S., where volumes were relatively flat, as well as Asia, where deliveries increased 5% year over year, have helped support the enthusiasm.

The producer expects the good times to continue. Management believes sufficient economic growth in the U.S. and China, the main purchasers of iron ore, will provide continued strong demand. In response, Cliffs plans to increase U.S. production around 10% and maintain Asian production at current levels.

The iron ore industry seems intent on boosting supply, fully confident that strong demand will continue. But circumstances in China suggest future orders might fall short of these expectations.

A troubling Chinese demand driver
One key driver of recent strong iron ore demand appears tenuous. There have been reports Chinese steel mills and traders have elevated purchases not due to manufacturing needs but mainly as collateral to secure loans -- a reasonable explanation for the country's voracious appetite for the ore even as signs of a slowing economy have emerged.

Commodities have often been used as collateral for loans in China. Since banks have tightened lending in overbuilt manufacturing sectors, increased security is needed to get or renew borrowings. Supply figures seem to support the notion that Chinese iron ore deliveries are not being consumed. Recent inventory levels have exceeded 100 million tons for the first time since July 2012, according to data from Shanghai Steelhome Information Technology.

Reports that commodity traders obtain cheap loans to purchase the mineral and then sell it quickly to speculate with the proceeds only seem to increase the fragility of this kind of finance-based demand. These traders, aiming for short-term gains in areas like real estate, usually have to pay back the borrowings within three to six months.

Demand based on these financial purposes rather than use appears to be an unreliable and unsustainable source of iron ore growth. Any retrenchment in the use of the mineral for financing, especially in a time of rising supply, would likely buckle ore pricing and be seriously detrimental to miner results and share prices.

Longer-term positives could present a buying opportunity
While short-term difficulties in the iron ore industry might be likely, any meaningful share price decline could provide a long-term buying opportunity. The industry has become incredibly lean over the last year. Rio Tinto undertook a comprehensive cost cutting program, which more than met expectations. The company reduced capital spending by 26%, eliminated $2.3 billion in other expenses, and cut debt by 18%.

BHP Billiton is also clamping down on expenses. It plans to spend 27% less on new projects this year and save around $5.5 billion from cost reductions and efficiency gains. Cliffs Natural has made similar financial progress. It announced a $90 million expense cut for 2014 with plans to slash capital spending and idle or divest underperforming assets to conserve even more cash.

These impressive cost cutting efforts have put the miners in a noticeably improved financial position, making them prone to rebound strongly if short-term iron ore price volatility does violently disturb the industry.

Bottom line
Iron ore producers like BHP Billiton, Rio Tinto, and Cliffs Natural Resources have recovered nicely from their 52-week lows. But increased supply and a potential drop in Chinese demand indicate another downturn may be approaching. Though near-term results and share prices may suffer if such a slump does occur, these miners, with improved balance sheets, might offer an excellent buying opportunity on any meaningful stock price drop.

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Bob Chandler

A dedicated Graham-style value man, Bob bought his first stock in 1986 and though he’s a miserable market timer, longer-term calls let him earn a meager living from his investments. With an MBA and MS in Accounting, Bob relies more on Hetty Green's advice for successful investing: "Buy cheap and sell dear. Act with thrift and shrewdness and be persistent."

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