Iron Ore Prices Are Less Important Than You Think

Iron ore prices have sagged recently. The commodity is trading almost 30% lower than at the first of the year. While there has been a slight uptick in the last week, there is no consensus on whether this is a temporary rise based on recent news or a shift in the underlying fundamentals. 

Declining supply plus rising demand equals higher prices
The more bullish outlooks focus on the recent good news coming out of China. Manufacturing increased in June, signaling that the government's "mini-stimulus" is having the desired effect. Increased manufacturing activity from the world's largest consumer of ore will push up demand.

On the supply side the bulls see domestic Chinese mines cutting production. Low-cost imports are making domestic production unprofitable. So while mills are increasing output, domestic production is expected to decline significantly this year and next.

With the declining domestic production many analysts are predicting stable ore prices at worst for the remainder of 2014. JPMorgan Chase sees prices rising at least 13% to $105 per ton, believing Chinese domestic production must fall almost 150 million tons in the next 18 months.

Too much inventory keeps prices flat to low                                                                  
On the other side of the spectrum UBS is predicting ore prices to remain stable at around $90 per ton. Overcapacity is the main culprit for its forecast.

On this view the domestic production remains flat and any increase that is seen comes from domestic producers destocking their ore inventories in an effort to secure working capital. This explains why their inventories remain high at Chinese ports.

So what should investors do when looking at iron ore producers and iron ore pricing predictions?

Price is not all-important for some                                                                                        
The big iron ore miners do not seem to be overly affected by iron ore price movements.

Iron Ore Spot Price (Any Origin) Chart

Iron Ore Spot Price (Any Origin) data by YCharts

Despite the spot price of iron ore falling almost 30% in the calendar year Vale (NYSE: VALE  ) has lost slightly more than 5% of its price. Rio Tinto's  (NYSE: RIO  ) price has risen almost 2% and BHP Billiton's (NYSE: BHP  )  has risen slightly as well.

But for others, price is super-important                                                                          
On the other hand, smaller producers do appear to be more affected by the spot price.

Iron Ore Spot Price (Any Origin) Chart

Iron Ore Spot Price (Any Origin) data by YCharts

ArcelorMittal  (NYSE: MT  ) has seen its share price decline by over 13% since the beginning of the year. More dramatic has been Cliffs Natural Resources  (NYSE: CLF  ) . Its stock has declined by almost 40% since the start of the year: from roughly $26 per share to under $16 a share. 

Granted, Cliffs' weakness cannot all be blamed on the fall in iron ore prices -- the company is involved in a nasty shareholder battle. But it appears clear to me the company is more susceptible to iron ore value than the bigger three producers.

Economies of scale promote healthier operating margins                                       
The difference between the larger producers and the small producers is a good lesson in economies of scale. The larger miners have lower costs, and are more diversified to varying degrees. Iron ore price drops will not hurt them nearly as much as it will smaller producers. As price drops, the less efficient producers are going to feel it more. Its the same reason Chinese domestic producers are shuttering their mines. Lower costs equal better operating margins.

VALE Operating Margin (TTM) Chart

VALE Operating Margin (TTM) data by YCharts

Don't worry so much if you invest with a big 3                                                             
The bottom line for investors is that if you are invested in one of the larger ore producers then there is no need to worry much about iron ore prices. These companies are still going to churn out profits even if ore drops well below the most bearish of analysts' predictions.

On the other hand, if you are convinced that ore prices will meet or exceed the more optimistic ends of predictions then it might be worth investigating the smaller ore producers. A significant rise in price would most certainly produce healthy returns with these investments.

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