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A Bear Market for Iron Ore Is Bad News for These Miners

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Iron ore prices continued to slump on Monday, entering into bear market territory as China weighed heavily on the market. After registering strong gains in 2013, iron ore prices have tumbled this year. Sharp declines in iron ore prices could shut down some high-cost mines in China, which should help mining giants such as Vale (NYSE: VALE  ) , BHP Billiton (NYSE: BHP  ) , and Rio Tinto (NYSE: RIO  ) . But miners shouldn't rejoice, as Chinese policymakers' determination to rebalance the economy could weaken long-term demand for iron ore from the world's biggest consumer of the bulk commodity. With iron ore supplies set to increase this year, this could create a significant glut, which would hurt iron ore prices even more and significantly reduce miners' free cash flows.

Iron ore prices slump
Iron ore prices tumbled nearly 9% to $104.70 a ton on Monday. The commodity slumped after the release of disappointing Chinese trade data over the weekend. China's exports dropped 18.1% in February, and as a result China's trade balance swung into a deficit. The weak trade data comes on the back of some disappointing manufacturing data, highlighting the fact that the Chinese economy is seeing a slowdown.

Iron ore futures on China's Dalian Commodity Exchange dropped almost 6% to 728 yuan a ton. According to Reuters, this is the weakest level since the exchange launched iron ore futures on October 18.

China is the world's top consumer of iron ore, and any weakness in the world's second-largest economy has a negative impact on prices. Apart from the weak Chinese economic data, another reason for the drop in iron ore prices is concern over trade financing deals under which Chinese steel mills use iron ore as collateral to secure loans.

As I noted in a previous article, China's credit squeeze has forced financially stretched steel mills to secure loans using iron ore as collateral. This explains the significant increase in iron ore stockpiles at Chinese ports. As per data from Steelhome, iron ore stockpiles rose to a record of 105 million tons on Friday. Last week, a Chinese solar equipment maker defaulted on its debt. Following the default, rumors surfaced that a steel mill in China's Shanxi province shut 5 to 6 furnaces. The rumors have sparked concerns that some of the trade financing deals that used iron ore as collateral could turn sour.

Iron ore prices have already fallen more than 20% this year, entering into a bear market. The sharp decline means that some high-cost mines in China could be shut down. This would help miners such as Vale, BHP Billiton, and Rio Tinto, but falling prices also mean that mining giants would see a significant drop in their cash flows. Also, China's determination to rebalance its economy means that demand for iron ore is expected to remain subdued. Given that iron ore supplies are set to increase this year, this could create a glut, further hurting prices.

Rebalancing the economy
Despite weakness in the Chinese economy, the country's policymakers have so far not shown any urgency to boost growth like they did during the financial crisis of 2009. In fact, Chinese policymakers' reluctance to act in the wake of a weakening economy suggests that they are determined to rebalance the economy from export and investment-led growth to consumption-led growth.

This was also confirmed last week when Shanghai Chaori Solar Energy Science & Technology Co., a maker of solar equipment, defaulted on its debt. Although the default is not likely to lead to a contagion, Chinese policymakers in the past would have intervened. However, this time they did not act and allowed a corporate debt default for the first time in recent history. This suggests that policymakers do not mind shedding some overcapacity in sectors they see as overheated. Steel is one such sector. If indeed this is the case then Chinese demand for iron ore, a key ingredient in steelmaking, could remain subdued in the long term. Given the importance of Chinese demand for iron ore, this will have a significant impact on pricing, especially as there are expectations of an increase in supply this year from the likes of BHP Billiton and Rio Tinto.

Impact on miners
An increase in iron ore prices last year helped the likes of Rio Tinto, BHP Billiton, and Vale post strong financial results. With iron ore prices now entering into a bear market, what does it mean for miners? Rio had said in January that a 10% drop in iron ore prices would have reduced its underlying earnings by $1.2 billion in 2013. BHP Billiton had said that a 10% increase in the average realized price for iron ore increased its underlying EBIT by $964 million. Given that iron ore prices are now down more than 20% this year, miners are expected to see a significant drop in their underlying profits. Not surprisingly, shares of Vale, BHP, and Rio fell sharply in early trading on Monday.

It must be noted that miners have been implementing cost-cutting measures and adjusting to a changing environment. However, BHP, Vale, and Rio Tinto rely heavily on robust iron ore demand and prices. If China continues to rebalance its economy, all three companies will see a significant reduction in their free cash flows.

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Varun Chandan

I have a Master in Finance degree from IE Business School in Madrid. I use the top-down approach when it comes to investing. I like to analyze macroeconomic factors and how they impact individual companies.

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