Can these companies survive a falling iron ore price?

Is there a floor to iron ore prices?

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Australia’s iron ore miners might start praying for more Chinese stimulus action, after spot iron ore prices fell to a 10-month low of US$118 a tonne overnight. The problem for the miners is that as they announce record production, demand for iron ore falls, and along with it the price. BHP Billiton Limited (ASX: BHP) recently announced a 15% increase in iron ore production.

With massive iron ore projects coming on stream, and production volumes expected to increase dramatically, it’s possible the iron ore price dive further.

The Australian Financial Review has also reported that spot sales were slowing and steel mill customers are asking the big miners to delay contracted shipments. Chinese steel mills have produced record volumes of steel this year and exported a record amount of steel in order to offset weak domestic demand. Analysts have suggested the steel mills are still producing more steel than can be used, and so will need to cut back their production at some stage.

In a report today, The Sydney Morning Herald (SMH) has suggested that there is an iron ore price floor of around US$110 a tonne. That level is where high-cost Chinese iron ore producers start to become uneconomic, and should the price fall below that level, would go out of business. Brazilian mining giant, Vale SA works with a price floor of US$120 a tonne, as small Chinese mining companies tend to suspend production or build stock levels around that price, causing diminishing supply. According to the SMH, those producers supply around 30% of China’s iron ore needs, so China’s steel producers would be left with no alternative but to cut production of steel, or import more iron ore. That would be good news for iron ore miners including the big three BHP Billiton, Rio Tinto Limited (ASX: RIO) and Fortescue Metals Group Limited (ASX: FMG).

Pure-play Atlas Iron Limited (ASX: AGO), Australia’s fourth largest iron ore miner, is also likely to benefit, and with estimated cash costs of less than A$50 a tonne, could still survive large falls in the iron ore price.

Fortescue Metals reported cash costs of around US$50 a tonne in its latest quarterly report, but has to service debts of $9 billion, so the company needs the iron ore price to stay relatively high. BHP and Rio don’t report their iron ore cash costs, but media reports suggest it costs them much less than US$46 a tonne to dig their iron ore out.

Short-term contracts

Starting around two years ago, most of the major iron ore producers moved to short-term quarterly price contracts, giving them more exposure to the higher commodity price at the time. The flip side of that is the miners face more risk to short term movements in the commodity price. We could see a return to longer-term contracts, should prices look like falling further.

The Foolish bottom line

All eyes will be on the crucial iron ore price. We are yet to see the implications of a lower iron ore price for our miners, but we may get the chance to find out. A falling iron ore price could put some weaker players out of business, but even for those who are left, could significantly crimp their profits. It’s no wonder investors are nervously watching China.

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Motley Fool writer/analyst Mike King owns shares in BHP. The Motley Fool‘s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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