Iron ore, the top commodity in 2013, is continuing its disastrous run this year. On Friday, iron ore prices dropped to a 20-month low amid weakness in China -- the most important market for iron -- and increasing supply. Indeed, the outlook for iron ore has turned bearish, which is worrying for miners such as Rio Tinto (NYSE:RIO), Vale (NYSE:VALE), and BHP Billiton (NYSE:BHP).
Prices at a 20-month low
Iron ore had an excellent run last year; however, the key steelmaking ingredient has struggled since the start of this year. The biggest reason for the sharp decline in iron ore prices has been a slowdown in China, which consumes two-thirds of global seaborne iron ore. The losses have been exacerbated by an anticipated increase in supply.
Over the last few years, demand for iron ore exceeded supply. China, of course, was the primary driver for this demand. The world's second largest economy consumed the bulk commodity as it invested heavily in infrastructure. However, after years of relying on export- and investment-led growth, China is finally looking to rebalance its economy.
China is also looking to cool down sectors related to the property market and cut overcapacity in sectors such as steel. Despite these factors China has imported vast quantities of iron ore this year, but much of the imports have been used as collateral in financing deals. Given China's focus on rebalancing its economy, long-term demand for iron ore is expected to weaken.
Meanwhile, miners such as BHP and Rio have been ramping up production. As a result, the iron ore market is expected to go into a surplus this year. And given the changing demand/supply fundamentals of the iron ore market, the surplus is expected to remain. Not surprisingly, iron ore prices have struggled since the start of this year.
On Friday, prices hit a 20-month low. Prices for benchmark 62% iron ore dropped 2% to $100.70 per ton, which is the lowest level since September 2012. According to Macquarie, the average price of iron ore for the third quarter is expected to be $100 per ton. This is down from the bank's previous forecast of $115 per ton. More importantly, prices are expected to fall further in 2015 and beyond. So what does this drop in prices mean for miners?
What this means for miners
For high-cost miners in China and Australia, a price of around $100 per ton means they will not be able to sustain. The story is different for mining giants though. All three major iron ore miners -- Rio, BHP, and Vale -- have low costs. Vale has the lowest cost among miners.
In the first quarter of 2013, the Brazilian mining giant's iron ore cash cost per ton, excluding iron ore from third parties, was $21.59. However, after adding freight costs and depreciation, the company's costs almost doubled to become more or less similar to those for Australian miners Rio and BHP.
Given that major mining companies have costs of around $45 per ton, even a price of $80 per ton, which is a possibility in the next two years, is sustainable. However, profitability is not the worry for miners. The major concern for miners is the impact of low prices on their future cash flows. It must be noted that Rio and BHP have been looking to shed assets and focus on their core businesses, which include iron ore. Lower prices will significantly dent miners' future cash flows as well as hamper their ability to reduce debt levels and increase shareholder distributions.