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China calls time on iron ore industry

China’s steel production is estimated to have fallen by as much as 10% over the first few weeks of August, according to a report in today’s Australian Financial Review (AFR). A sluggish construction market and a lack of additional stimulus by China’s government has seen the Chinese steel mills stockpile product to record levels. China looks set to record its first annual slump in steel production in 31 years according to the report.

Data from the China Iron and Steel Association (CISA) show inventories were 26% higher than last year. According to the AFR report, local Chinese government authorities force many steel mills to keep producing, even when it is uneconomic, to maintain tax revenues, jobs and to show Beijing that they are delivering on economic growth targets.

The issue for Australian iron ore producers, like BHP Billiton (ASX: BHP), Rio Tinto (ASX: RIO), Fortescue Metals Group (ASX: FMG) and Atlas Iron (ASX: AGO) is that China appears to be allowing the economy to slow. Further stimulus for the country’s steel sector is unlikely to materialise, which will disappoint our miners who had been expecting the Chinese government to step in.

Without further stimulus measures, the price of iron ore could fall much further than its current price around US$110 a tonne. Prices have already fallen by around 20% since early July. Many iron ore miners and analysts have speculated that there is a natural floor to iron ore prices at around US$120 a tonne. At these levels, Chinese steel mills become uneconomic, start stockpiling their resources or stop production. Looks like the first part has already started.

Apart from falling commodity prices, it appears demand for iron ore is also likely to slow – a double whammy for iron ore producers globally. At the same time, many miners are ramping up production, which could put further downward pressure on the iron ore price.

The Foolish bottom line

Resources companies have until recently been priced like growth companies, with expectations of consistent growth for years and years. They are in fact cyclical companies, subject to the whims of demand and commodity prices, and could be entering their downward cycle.

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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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