Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



Lower Iron Ore Prices Are Not a Big Threat for Major Producers

Watch stocks you care about

The single, easiest way to keep track of all the stocks that matter...

Your own personalized stock watchlist!

It's a 100% FREE Motley Fool service...

Click Here Now

Australian Bureau of Resources and Energy Economics has recently revised its iron ore price forecast for this year. It expects prices to average $110 per ton this year, together with further decrease to $103 per ton in 2015. The main reason for this downward revision is the slowing economic growth in China and growing production from BHP Billiton's (NYSE: BHP  ) and Rio Tinto's (NYSE: RIO  ) Australian iron ore mines. While this news might seem bearish for some investors, I think that lower iron ore prices have already been priced in for the shares of major iron ore producers.

Growing production will likely offset low prices
A weak Australian dollar continues to positively contribute to BHP Billiton's and Rio Tinto's costs. As the costs remain low, the companies can offset lower margins by growing production. Vale (NYSE: VALE  ) , which got 72% of its revenue from its iron ore segment in 2013, also continues to grow its production. Vale's performance is directly tied to the health of the Chinese economy, as China represented 48% of its iron ore segment sales in 2013. This means that news from China is more important to Vale than fluctuations of the iron ore price.

The fact that the growing production will put additional pressure on prices was widely recognized by the producers themselves. It looks like major iron ore suppliers are happy with the current situation, as it forces less cost-efficient and smaller players to leave the market. This strategy will allow them to grow their market share at the expense of the weaker companies.

At first glance, one might say that big miners are playing with fire, as their production growth erodes their own margins. However, the strategy looks viable from a long-term point of view, as low costs prevent companies' cash flows from going into negative territory.

What if iron ore price softness lasts longer than two years?
One should always consider a negative case scenario when assessing a company's future. So, what happens if iron ore prices plunge below the $100 mark in 2016 and stay there for some time? For sure, BHP Billiton, Rio Tinto, and Vale will feel the pain of such a drop. However, by that time the companies' current expansion projects will be mostly completed, which will lead to lower capital spending, somewhat offsetting the margin erosion.

What's more, I don't believe that iron ore pricing below $100 is sustainable. For example, Cliffs Natural Resources' (NYSE: CLF  ) Canadian operations had cash costs of $110.03 per ton of iron ore in the fourth quarter, which led to a negative sales margin of $23.57 per ton. The performance of Cliffs Natural Resources' Australian mines was dramatically better with cash costs of just $58.90 per ton.

Cliffs Natural Resources could wait for improvement on the pricing front for some time. However, the situation when one company's segment is sponsoring the other could not last forever. Should iron ore prices dip lower, Cliffs Natural Resources could be forced to idle its Canadian mines. The same thing will happen to many smaller iron ore producers in case of sub-$100 iron ore prices. This will take excessive production out of the market and drive prices higher.

Bottom line
While the flood of production of Australian iron ore mines hurts smaller producers, big players are up for the challenge. In the long term, they will gain bigger market share and increase profitability.

Boost your 2014 returns with The Motley Fool's top stock
There's a huge difference between a good stock and a stock that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2893173, ~/Articles/ArticleHandler.aspx, 8/29/2015 5:05:30 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Vladimir Zernov

Vladimir Zernov believes that fundamental analysis works best with energy and materials stocks and covers them on Motley Fool.

Today's Market

updated 19 hours ago Sponsored by:
DOW 16,643.01 -11.76 -0.07%
S&P 500 1,988.87 1.21 0.06%
NASD 4,828.33 15.62 0.32%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

8/28/2015 4:02 PM
BHP $36.69 Up +0.69 +1.92%
BHP Billiton Limit… CAPS Rating: ***
CLF $3.83 Up +0.10 +2.68%
Cliffs Natural Res… CAPS Rating: ***
RIO $36.60 Up +0.04 +0.11%
Rio Tinto plc (ADR… CAPS Rating: ***
VALE $4.83 Down -0.17 -3.40%
Companhia Vale Ads CAPS Rating: ****