How will slowing demand for iron ore affect our miners?

Demand growth for steelmaking ingredient iron ore is expected to continue slowing down in the near future, which will have a negative impact on the earnings of heavyweight companies like BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO).

According to the World Steel Association, global demand is expected to rise just 3.1% in 2014 to 1.52 billion tonnes and then 3.3% in 2015, compared to the 3.6% growth recorded last year. At the same time, Australia’s largest miners are heavily ramping up their production levels of the commodity which will apply a downwards pressure on the price of iron ore.

The commodity has already fallen dramatically in value since the beginning of the year. While it has made a recovery in recent weeks after plunging as low as US$104 a tonne in March, it is still sitting roughly 11% below its levels entering into 2013. Many analysts – Goldman Sachs among them – believe that it could fall to as low as US$80 a tonne within the next two years, which would imply a 33% downside from today’s price.

To combat that downside, the miners are heavily focused on reducing operating costs and improving productivity to achieve a better breakeven level. BHP’s and Rio Tinto’s breakeven price is currently sitting at around US$45 a tonne while Fortescue Metals Group Limited’s (ASX: FMG) breakeven point is estimated to be around US$70 a tonne. While these figures will continue to decrease as production rises, the lower commodity prices will still have an impact on their overall profitability.

Foolish takeaway

Given the heavy reliance that Rio Tinto and Fortescue Metals have on iron ore for their overall earnings, investing in them today could be quite a risky move. Any downwards movement in the commodity’s price will likely be reflected in their share prices.

BHP, on the other hand, represents a safer bet. Although iron ore remains its primary revenue generator, it is also much more diversified with its focuses on copper, coal and petroleum, as well as potash which will likely become its “fifth pillar”. Its earnings could be restricted in the short-term due to pricing pressures on copper and coal, but it’s the safest bet for the long-term.

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Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned.

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