The Mining Investor's Handbook – Part 3 – Iron Ore

Part 3 of this extensive series looks into the iron ore industry including the major companies and some of the current risks facing the industry.

| More on:
a woman

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

In my previous article, I outlined Australia's main mineral resources, where they are located and our major customers. We will now delve deeper into our key commodities starting with our largest export, iron ore.

Iron ore

Iron ore has polarised the country over the past few years. Whether the price is crashing or soaring, the industry hits the headlines regularly. Either the global giants – Rio Tinto Limited (ASX: RIO) and BHP Billiton Limited (ASX: BHP) – aren't paying their fair share of tax, Andrew Forrest declaring that these global giants are harming our national interest, or Gina Rinehart battling her children in another family feud. This must be keeping some journalists in a job!

Australia's iron ore industry has boomed over the past 15 years. In 2001, we exported 176 million tonnes (176Mt) for sales of $5.7 billion. Fast forward to 2014 when we exported 700Mt for $65 billion.

Iron Ore 15 Year and output

From 2004, rapidly increasing Chinese demand for iron ore sent the iron ore price skyrocketing towards a peak of $185/t in 2011. As prices trended upwards the industry was in a frenzy. New companies were being created – hello Atlas Iron Limited (ASX: AGO) and BC Iron Limited (ASX: BCI) – and dozens of Australian iron ore projects were approved for construction. What could possibly go wrong?

A big issue with mega mining projects is the time required to construct them. Gina Rinehart's Roy Hill project, a 55Mt per annum mine approved in 2011 when prices were well above $100/t, is expected to come online in late 2015. The initial investors, licking their lips at the prospect of a $50/t gross profit margin, must be horrified to know the project is barely breaking even at current prices.

In 2014, China imported around 75% of Australia's iron ore production and consumed 700 million of the 1,500 million tonnes of the global steel demand. The transition of China's economy from being driven by investment to that of domestic consumption has stunted the growth of the iron ore industry. Chinese steel demand in the coming years is uncertain, however, one thing can be assured: the strong growth of the past decade is over.

At this time of waning growth and uncertainty, the four major iron ore producers are still expanding and pumping out record tonnes at a low cost that has flooded the seaborne market and depressed prices which could prove to be fatal for many higher cost producers like Atlas Iron and BC Iron. The largest US iron ore producer, Cliffs Natural Resources, has recently – and possibly wisely – announced plans to exit its Australian iron ore market citing poor profits as the key driver.

The global cost curve shown below indicates the production cost per tonne of iron ore for various companies and countries and it highlights the high-cost of domestic Chinese iron ore production.

FMG global cost curve source

As the lower cost tonnes from Rio Tinto, BHP, Vale and Fortescue Metals Group Limited (ASX: FMG) (left-hand side of chart) enter the global market they will continue to depress prices which in theory will force higher-cost domestic Chinese iron ore operations to exit. How long this will take is unknown. Adding to the uncertainty, high-cost Chinese production (right-hand side of chart) does account for hundreds of millions of tonnes and there may be regional and political reasons for Chinese companies to continue running these mines.

So what is iron ore?

Iron ore is a bulk commodity and 98% of global production is used in steel production.  As with most iron ore mines throughout the world, the major Australian mines are open-pit and they are some of the largest mines in the country. Most major operations transport the iron ore from the mine site via huge trains to the coastal ports – Port Hedland, Dampier and Cape Lambert – where it is loaded into ships for export.

There are two main types of iron ore produced globally – hematite and magnetite. Hematite accounts for more than 95% of Australia's exported iron ore and is often termed direct shipping ore (DSO) as it requires a simple process of crushing and screening before being exported at grades between 58-62% Fe (amount of iron content) for use in steel production.

BHP and Rio Tinto export iron ore at an average grade of 62% Fe whilst Fortescue exports at a significantly lower average grade of 58% Fe and this ore generally contains higher percentages of impurities including silica, alumina and phosphorus. The grade and impurity levels make a dramatic difference to the price customers will pay for the ore. For the 6 months from July to December 2014, Rio Tinto, BHP and Fortescue realised an average price of US$82/t, US$76/t and US$60/t respectively. This clearly shows the large discount Fortescue receives for its lower quality ore.

Magnetite ore in its natural state has a lower iron content, typically between 25-40% Fe. The lower grade ore needs to be upgraded through an energy intensive process of crushing and concentrating before it is fed into a blast furnace to create a pellet suitable for steel production. After processing, magnetite has a higher grade (typically 65-68% Fe) and lower impurities than hematite and, therefore, commands a premium price.

Grange Resources Limited (ASX: GRR) operates the Savage River magnetite mine in Tasmania and is the only significant Australian magnetite pellet producer. In contrast to BHP, RIO and Fortescue, Grange Resources' premium magnetite pellets realised an average price of US$117/t, nearly double Fortescue's average price.

The big players

You may be familiar with our big three Australian iron ore producers, Rio Tinto, BHP and Fortescue, but Brazil's diversified miner Vale is the largest iron ore producer in the world. Together, these four giants dominate around 70% of the global seaborne iron ore trade with a combined production of more than 900 million tonnes in 2014.

IO Production 2010-2015 Vale Rio BHP FMG

Fortescue and BHP have added the largest number of additional tonnes into the global system over the past 5 years.

In 2014, iron ore contributed 50% of earnings before interest and tax (EBIT) to BHP, nearly 70% for Rio Tinto, whilst Fortescue is a pure play and generates 100% of its earnings from iron ore. Therefore, all three companies are highly leveraged to the price of iron ore.

In my next article, we will take a closer look at the precious metal that has captivated both women and men for thousands of years: gold.

Motley Fool contributor Mitch Sonogan has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

More on ⏸️ Investing

Close up of baby looking puzzled
Retail Shares

What has happened to the Baby Bunting (ASX:BBN) share price this year?

It's been a volatile year so far for the Aussie nursery retailer. We take a closer look

Read more »

woman holds sign saying 'we need change' at climate change protest
ETFs

3 ASX ETFs that invest in companies fighting climate change

If you want to shift some of your investments into more ethical companies, exchange-traded funds can offer a good option

Read more »

a jewellery store attendant stands at a cabinet displaying opulent necklaces and earrings featuring diamonds and precious stones.
⏸️ Investing

The Michael Hill (ASX: MHJ) share price poised for growth

Investors will be keeping an eye on the Michael Hill International Limited (ASX: MHJ) share price today. The keen interest…

Read more »

ASX shares buy unstoppable asx share price represented by man in superman cape pointing skyward
⏸️ Investing

The Atomos (ASX:AMS) share price is up 15% in a week

The Atomos (ASX: AMS) share price has surged 15% this week. Let's look at what's ahead as the company build…

Read more »

Two people in suits arm wrestle on a black and white chess board.
Retail Shares

How does the Temple & Webster (ASX:TPW) share price stack up against Nick Scali (ASX:NCK)?

How does the Temple & Webster (ASX: TPW) share price stack up against rival furniture retailer Nick Scali Limited (ASX:…

Read more »

A medical researcher works on a bichip, indicating share price movement in ASX tech companies
Healthcare Shares

The Aroa (ASX:ARX) share price has surged 60% since its IPO

The Aroa (ASX:ARX) share price has surged 60% since the Polynovo (ASX: PNV) competitor listed on the ASX in July.…

Read more »

asx investor daydreaming about US shares
⏸️ How to Invest

How to buy US shares from Australia right now

If you have been wondering how to buy US shares from Australia to gain exposure from the highly topical market,…

Read more »

⏸️ Investing

Why Fox (NASDAQ:FOX) might hurt News Corp (ASX:NWS) shareholders

News Corporation (ASX: NWS) might be facing some existential threats from its American cousins over the riots on 6 January

Read more »