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Should you buy iron ore stocks?

Stocks of the world’s biggest iron ore producers like Rio Tinto (ASX: RIO) and Vale SA in Brazil have fallen unreasonably according to some overseas fund managers, but is now the right time to buy?

Compared to prices in February this year, our two biggest producers of iron ore, Rio and BHP Billiton (ASX: BHP) have dropped 11.39% and 10.7% despite a rally in prices the last fortnight. Prices have bounced back as investors were perhaps caught by surprise when they both produced record output of a number of commodities.

For BHP, iron ore is still the most lucrative product and the return on assets is approximately 75.8%. Rio relies on the steelmaking ingredient for approximately 80% of revenues but has a slightly smaller ROA.

When the next round of annual or half yearly reports come out, miners’ revenues will be affected by a reduced spot price of iron ore, which has dropped from an average of $140.60 per tonne to $136 per tonne in the first six months of the year. Lesser quality product has dropped even further and the fall in the AUD has been unable to counteract it.

However, it is only going to get worse for our miners, as analysts at Goldman Sachs and Macquarie Commodities Research believe that iron ore could fall to as low as $80 to $88 per tonne in the mid to long term.

This will come about as a result of miners’ investment in projects before the GFC coming online between now and 2015. BHP, Rio and Vale have been the biggest drivers for the increased production. However research suggests that by 2018 the market will have about 419 million tonnes of surplus ore, 40% of the global seaborne traded levels in 2012.

The bulls

However, these new projects are likely to be even lower cost than existing mines. Vale’s Serra Sul is expected to produce iron ore for as little as $15 per tonne whilst current operations produce at $24 per tonne. The realisation of extremely low cost of production and large margins has pushed up our local producers’ share prices in the past two weeks.

Evy Hambro, portfolio manager of BlackRock’s World Mining Fund has said “iron ore companies are producing iron ore at $30-$50 a tonne… but supplied prices are averaging $90 – $120 a tonne”. Mr Hambro said “iron-ore equities have been sold off among the general selling and nervousness over growth in supply, but they can still make a good return”.

Bulls also believe that China’s slowing growth is not much of a concern, as the economy will be influenced by more infrastructure spending in the next 5 to 10 years and the recovering US economy will also support prices.

Steven Randell, managing director of the Steel Index, believes lower prices will remove smaller suppliers from the market therefore increasing the bigger miners’ market share which could buffer prices. “Around $110, the markets understanding is that many projects start falling off the viability cliff: it’s a bit of a tipping point… and at $100 a tonne only a small section is viable”.

Foolish takeaway

There’s no doubt there could be value in some of our biggest miners in the short or long term. However, you only have to look as far as coal stocks to get a feel for what oversupply can do to your portfolio.

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Motley Fool contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies. 

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