For the past couple of years analysts have been forecasting a sharp drop in the iron ore price. Obviously this has big ramifications for the iron ore miners, especially those with higher costs per tonne.
So before any investment in iron ore stocks is made, it's imperative investors take this into consideration, even if they don't agree with it. Let's take a look at what it all means for Rio Tinto Limited (ASX: RIO).
Throughout 2013, Rio – Australia's biggest and lowest cost iron ore miner – realised a price of US$126 per tonne of iron ore produced. Not bad for a miner which can dig up and ship high quality ore for less than $US50 per tonne.
In 2014 however, it appears the bears could be right about the iron ore price. Just check out the graph below which shows the monthly average iron ore price over the past five years up until March 2014.
Source: indexmundi.com
The proposed catalyst for falling spot prices is forecast global oversupply of the steelmaking ingredient coupled with a slowdown in infrastructure investment throughout China – the world's biggest consumer of iron ore.
Rather than a dramatic price drop to $US90 per tonne in 2015 – as some analysts are expecting – the Bureau of Resource and Energy Economics (BREE) believes an average price that low won't be achieved until 2018. This leaves plenty of time for miners like Rio, BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG) to pay down debt and return excess funds to shareholders.
However, the market still isn't holding out much hope and both Rio (which draws a majority of its earnings from iron ore) and Fortescue (a pure play iron ore miner) shares currently trade on forward price-earnings ratios of 11 and 4.9, respectively. Currently the iron ore spot price is approximately $US111 per tonne.
At current spot prices, I believe Rio's forecast FY14 production of 295 million tonnes (mt) – up from 265mt in FY13 – could be enough to counteract the reduction in commodity prices.
The secret to whether, or not, Rio will be capable of growing shareholder wealth in 2014 (thereby keeping it safe) is outside of its iron ore division.
In FY13, Rio made US$10.2 billion in underlying earnings thanks to lower costs and increased production. Unfortunately write-downs of US$3.43 billion took their toll on group earnings. If Rio can get its Coal (part of its Energy division) and Aluminium businesses under control and avoid write-offs then there is a big chance the miner could grow earnings substantially in 2014.
Foolish takeaway
If you're willing to take a punt on iron ore remaining at its current level, Rio could be a worthwhile investment because it minimises downside risks thanks to its relatively modest share price and low costs per tonne. Fortescue has a higher break-even point and more debt but could be equally, if not more, rewarding. I would steer clear of other, higher cost producers like Arrium Ltd (ASX: ARI) and Atlas Iron Limited (ASX: AGO), unless your very bullish on the iron ore price because a sustained drop in prices (perhaps to below $US90 per tonne) would be extremely detrimental to their earnings.
