Here's Why the Price of Iron Ore Has Been Falling

BHP Billiton, Rio Tinto, and Vale have been increasing their iron ore output to drive the price down and peers out of business.

Jul 17, 2014 at 5:09PM

The iron ore industry is in turmoil. The price of the key steel making ingredient collapsed to a low of around $90 per ton at the end of June, a near three-year low, although it has since rebounded.

Some analysts have blamed this fall on a lack of demand from China. However, it would appear that the price of iron ore is being manipulated in favor of larger producers.

Specifically, BHP Billiton (NYSE:BHP) has recently revealed that it is ramping up iron ore production, which will drive the price down and could drive high-cost smaller producers out of business.

Controlling the market
Last month, BHP announced that it had shipped its billionth tonne of iron ore to Japan. Alongside this announcement the company also revealed that the global iron ore market was significantly oversupplied and, as a result, high-cost producers were likely to come under pressure. In particular, Mike Henry, BHP's president of marketing was quoted as saying:

"[there is] a significant overhang of low-cost supply coming to market in the face of a slow but steady increase in demand...it's really important for the high-cost suppliers to shut in a reasonably efficient manner in the face of that – otherwise you just see a compounding of supply in the market."

Essentially, what the mining executive is saying is low iron ore prices are here to stay, so get used to it .

BHP itself is ramping up its production of iron ore, so the company is well aware that it is compounding the supply problem. So, it would appear as if the company is seeking to drive high-cost producers out of the market, a plan which appears to be working well.

Indeed, a number of high-cost Chinese iron ore miners have been forced shut their doors for good recently. According to the China Metallurgical Mining Enterprise Association, around 20% to 30% of Chinese iron ore mines have closed so far, taking a large amount of supply off the market. Actually, even BHP itself has flagged the closure of some of its own Chinese iron ore mines amid a program to cut costs.

Uncompetitive
It's not surprising that so many Chinese producers are being forced to close up shop. According to data supplied by Bloomberg, around 80% of China's mines have operating costs of around $80 to $90 per ton. In comparison, BHP Billiton, Vale (NYSE:VALE) and Rio Tinto (NYSE:RIO) produce ore at around $53, $68, and $44 per ton respectively.

But it is not just BHP ramping up supply -- Rio Tinto and Vale are also ramping up output, compounding the supply problem.

BHP Billiton is increasing output by 260 million to 270 million tonnes from a 217 million tonne target in 2014, and Rio Tinto is on track to produce 295 million tonnes of ore this year, up from 266 million last year.

The perfect time
It is the right time for these iron ore industry leaders to launch this assault on high-cost producers. Historically, high-cost, unprofitable Chinese mines were kept in business by debt and loans from state banks. However, Chinese authorities have been cracking down on risky loans this year.

For example, the China Banking Regulatory Commission warned banks to tighten controls over letters of credit for iron ore imports earlier this year. This is a type of "shadow" financing which has been used to keep steel mills and traders afloat during times of stress. Keeping steel mills on life support as it were, kept demand for iron ore high; this demand is now likely to evaporate. Other measures have also been introduced to curb excessive risky lending.

So, with access to cheap debt restricted, Chinese iron ore mines will have trouble staying afloat.

Falling supply
All in all, according to Deutsche Bank, around 250 million tons of iron ore is expected to be taken out of the market as high-cost Chines mines close. Removing this supply could be enough to level out the market. Both BHP Billiton and Rio Tinto are going to dump around 130 million to 150 million tonnes of additional iron ore supply on the market this year. Analysts believe that the demand for iron ore over the same period is only set to expand by 30 million to 50 million tons. However, with Chinese supply dropping out of the market, the balance could be brought back in line, supporting prices.

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Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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