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Roy Hill Project Will Add to Iron Ore Supply Glut

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The slowdown in the Chinese economy has weakened demand for iron ore, pushing down prices. The slump in prices has also had an impact on shares of miners such as Rio Tinto (NYSE: RIO  ) , BHP Billiton (NYSE: BHP  ) , and Vale (NYSE: VALE  ) this year. Iron ore prices have slumped at a time when the market is expected to see a supply glut as miners increase production this year. The Roy Hill iron ore project, which recently secured funding, will further add to the supply glut and push down prices even more. This is not good news for miners such as Rio and BHP Billiton as they look to bring down their debt levels and increase shareholder distribution.

Roy Hill iron ore project
Australian mining heiress Gina Reinhart recently secured funding for her Roy Hill iron ore project in Western Australia's Pilbara region. Reinhart's Hancock Prospecting entered into a $7.2 billion financing deal with a consortium of 19 banks. With the funding secured, the project has moved a step closer to start shipping iron ore in 2015.

Reinhart wants to start exporting in September 2015. Annual production at the Roy Hill mine is expected to be 55 million tons, which would make it Australia's fourth largest iron ore producer. According to investment bank UBS, the mine is forecast to produce 15 million tons of iron ore in 2016. It is likely to reach full capacity by the end of 2017 or early 2018.

The mine will come online at a time when there is already expected to be a significant supply glut in the iron ore market.

Adding to supply glut
Iron ore was one of the few commodities to post gains in 2013, thanks mainly to strong demand from China, the world's largest consumer of the bulk commodity. In fact, miners over the years failed to keep pace with strong Chinese demand for iron ore. This, combined with a focus on maximizing cash flows from core assets, prompted mining giants such as Rio, Vale, and BHP to boost their iron ore production.

In November last year, Rio Tinto had said that it plans to optimize the growth of its iron ore business in Western Australia. The company said that from a base run rate of 290 million tons a year by the end of first half of 2014, mine production capacity will increase by over 60 million tons a year between 2014 and 2017.

The increase in production, though, is coming at a time when China is seeing a slowdown, which is hurting demand for iron ore. According to Xinhua, Chinese imported iron ore stockpiles rose for a sixth straight week, highlighting the weakness in demand. Given the expected increase in production and weak Chinese demand, the seaborne iron ore market is likely to a see a supply glut in 2014, something acknowledged by BHP and Rio Tinto last month.

BHP Billiton's head of marketing, Mike Henry, had said last month that seaborne supply is expected to rise by over 100 million tons in 2014, while global demand would rise by 60 million tons. The anticipated supply glut, coupled with concerns over Chinese demand and credit tightening, has resulted in a slump in iron ore prices this year. Given that China is trying to cool down its property market, which will hurt demand for steel, the supply glut in the iron ore market could keep growing. The Roy Hill project, when it comes online, will add to the supply glut. This could mean that prices could slip below $100 a ton.

Lower iron ore price is not good news for the likes of BHP and Rio Tinto, even though they have a low cost base. Both companies have played down the recent slump in iron ore price, but as I noted in a previous article, lower prices would hurt cash flows and delay their plans to bring down their debt levels and increase shareholder distributions. 

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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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