When thinking about iron ore producers it is very important to be clear about the difference in the near term versus that of the long term. There is little doubt that the iron ore market will continue to struggle in the near term. But all indications appear to me that the long term will be strong. Given this, investing in the large iron ore producers could provide tremendous value.
China drives the iron ore market
China consumes roughly two-thirds of global iron ore produced. There are serious causes for concern with Chinese demand. First, there are indications that the Chinese economy is slowing. Second, China is seeing a tightening of credit which is prohibiting the steel mills from purchasing ore. Third, there is a shift in economic policy -- moving from investment and export-led growth to a more consumer oriented economy. This will lead to less steel production.
This concern with the Chinese economy has led to a decline in iron ore prices. May saw the sixth straight month of declining iron ore prices. Forecasters predict another 10% to 20% decline over the year, yet supply continues to increase.
Negativity surrounding the market creates value
With all this negative news it is easy to ignore the iron ore producers and wait till the situation shows clear improvement.
But for those who want great value the next few months could be a perfect time to buy into the big iron ore producing companies.
The big 3 have low costs
Iron ore production is dominated by three companies that account for 66% of global production.
Vale (VALE +0.87%) operates the largest iron ore mine in the world in its home country of Brazil while Rio Tinto (RIO 0.38%) and BHP Billiton (BHP 0.43%) have large ore mine operations in Australia, Canada, and South America. These operations result in the three companies having the lowest operating costs in the market.
Low operating costs allow these companies to continue churning profits even as iron ore prices decline. While iron ore prices are now trading at under $100/tonne Rio Tinto could continue to turn a profit even if iron prices dipped to $50/tonne.
These three companies are going to be able to withstand a dip in prices of almost any duration. Other producers with higher operating costs are not going to be in such a position. Comparing the operating margins will show that companies like ArcelorMittal (MT 2.15%) and Cliffs Natural Resources (CLF +1.57%) are going to have a hard time surviving with any sustained dip in iron ore prices.
VALE Operating Margin (TTM) data by YCharts
Smaller producers will have to slow production
Sluggishness in the price and demand of iron ore will eventually result in smaller producers curtailing production, which will then result in a benefit to the big three producers. That is why I see value in the big three.
There are risks, of course. One of the biggest and most obvious is that sustained low prices will result in very slow growth for the big iron producers. But I see the likelihood of that as small. The urban populations in both India and China alone are expected to grow by well over half a billion people in the next decade. This growth will fuel a substantial rise in demand for iron ore.
Bottom line
It might be easier to hold off on iron ore producers until its seems clear that the price has hit bottom and Chinese demand shows improvement. But waiting too long will result in a loss of value for the big three producers. What I will look for are signs that the smaller producers are curtailing production. I believe that is the most important catalyst for a nice run.
