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Ignore the rally in iron ore prices. Despite import spot prices for 62% iron-content ore at the port of Tianjin, China that have jumped to almost $80 per metric ton, industry fundamentals continue to point to a coming collapse. As there seems little chance this won't happen, how the industry's biggest miners respond to it may determine just how long the depression will last.

Almost a year after iron ore prices reached a near-decade low of $37 per tonne, they've rallied across all of 2016, more than doubling in value and at one point hitting a two-year high of $79.81 per tonne. While shares pulled back to under $70 per tonne, they've rallied once more.

The higher prices have pulled the miners along with them. Shares of the world's biggest iron ore miner, Brazil's Vale (NYSE:VALE), are up over 150% this year, while Australian miners BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) recorded more modest gains of 53% and 42%, respectively, year to date.

The iron giant

Although there's no consensus on what one factor has caused the rally in pricing, particularly since there's no fundamental basis for it, Goldman Sachs believes the depreciation of the yuan against the dollar can account for 60% of the pricing rally in October, even though stockpiles are building up at Chinese ports, and just last week China's central bank set the value of the yuan to its lowest level against the U.S. dollar in more than eight years. Morgan Stanley has forecast there will be a glut of 33.4 million tons of iron ore this year that will triple to almost 100 million tons by 2018.

It's just going to be too difficult for the market to retain those values. Vale, for example, just got the go-ahead to begin its four-year S11D expansion project at Carajas in the Brazilian Amazon that it anticipate will reach full capacity by 2018. Citigroup estimates Australian shipments will expand almost 12% to 934 million tons in 2020 from 835 million this year, while Brazilian shipments will surge 29% to 480 million tons.

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Still, the major miners are slowing the pace of production growth. BHP Billiton said its western Australia mines hit a record production of 257 million tonnes this year, but that was up just 2% from the year-ago period. Vale's third-quarter production was also a record at 92.1 million tonnes, but that was just 1.5% higher than in the same period last year. Year-to-date production is actually down 0.4% .

The bigger they are...

The problem for the industry is that if prices do fall, particularly if they fall hard as expected, it will be coming just as the need to start investing in developing new production will arise. According to Global Mining Research, over the next five to 10 years some 170 million tons of capacity will be lost to aging mines or those where the easy, premium grades have diminished. As much as $8 billion needs to be spent to develop new mines, but the bill will come due during a period of significant capital constraints.

Goldman Sachs predicts that total capital spending by mining companies worldwide will plunge about 60% next year. In particular, J.P. Morgan analysts estimate that Rio Tinto needs to develop a 50-million-ton mine about every five years simply to keep production steady, while Macquerie Group says BHP Billiton will need to replace about 30% of its current product when its Yandi mine in the Pilbara region of western Australia ceases production in 2023.

...the harder they fall

While analysts believe it will still be economical for the miners to invest in new production if prices are in the $50- to $60-per-tonne range, it's going to be a much different landscape if they tumble further than that, making the decisions more challenging.

First, the risks are not spread evenly. Rio Tinto, for example, has a much larger exposure to iron ore than does BHP Billiton. Some 60% of its fiscal second quarter underlying earnings before interest, taxes, depreciation, and amortization comes from iron while 83% of its net earnings are also reliant upon the mineral. 

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Still, they are among the industry's lowest cost producers. Earlier this year Citi put Rio's breakeven point under $30 per tonne while Fortescue Metals was almost $36 per tonne. ArcelorMittal is looking to end 2016 with free cash flow breakeven at $40 per tonne.

Dramatically lower prices will hit earnings -- Rio Tinto said pricing was by far the single biggest factor in the reduction in earnings it experienced year over year -- but they'll still be making a profit. Where the hammer will fall will be on the junior miners like Australia's Arrium, Atlas Iron, and BC Iron that have breakeven costs around $50 per tonne.

Whether producers will be able to reduce their costs further in a low-price environment than they already have is doubtful. Citi analysts say much of the breakeven cost reductions already achieved came from factors beyond control of management such as weaker currencies and lower freight rates. Future reductions will be minimal if any.

It may still be better to spend on iron ore than other metals and minerals, but they may end up putting projects into mothballs as other opportunities look better. Postponing development until prices recover is a smart business decision, but it still could change the investment thesis for these miners for the worse.