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 (BHP -1.45%) and Rio Tinto's (RIO -0.40%) 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 (VALE -0.51%), 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' (CLF 1.40%) 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.
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.