When it comes to iron ore production, Rio Tinto Limited (ASX: RIO) is first class. It's the world's second largest producer and Australia's biggest iron ore exporter. However, as the market braces for the possibility of falling iron ore prices, more investors are finding reasons to sell, rather than buy, the company's stock.
As a result of its dependence on iron ore, Rio trades on a price to earnings ratio of 8.7 whereas oil and gas producer, Santos Limited (ASX: STO), trades on a P/E of 25. The world's biggest iron ore producer, Vale SA (ADR) (NYSE: VALE), trades on a P/E of 11, while a bunch of smaller Australian producers such as Fortescue Metals Group Limited (ASX: FMG) and Mt Gibson Iron Limited (ASX: MGX) change hands at less than five times forecast FY14 earnings.
But for big producers like Vale, Rio and BHP Billiton Limited (ASX: BHP) is a potential fall in iron ore prices really all that bad? It seems investors clearly think so and have chosen BHP (which is bigger, more diversified and derives a much smaller percentage of its earnings from iron ore) as their way to get exposure to a possible upside in iron ore stocks.
With Chinese demand expected to somewhat plateau and each of the major iron ore producers set to ramp-up production considerably, analysts for some time have been forecasting a lower iron ore price. Currently iron ore sells for above $US100 per tonne, down from over $US120 per tonne this time last year.
For those considering investing in almost any commodity, the potential for falling spot prices is a real threat but an obvious one. As Andres Allende, CFA, pointed out on seekingalpha.com: "It is rather well understood that commodities prices eventually revert to the ninetieth percentile production cost level."
However it should be noted that Rio's, BHP's and Vale's breakeven price is estimated to be below $US50 per tonne, so it's unlikely any of them will go bust, even with the lowest prices being forecast.
However as more mines come online (whether they be high or low cost), the price of iron ore will fall and put pressure on Rio Tinto's and other miners' top lines. This would be the right time to buy iron ore producers for long-term gains.
As I've suggested before, the key to Rio's success will not only stem from its iron ore division, but also its other areas of business such as aluminium and copper.
Foolish takeaway
Since over 90% of Rio's underlying earnings are derived from iron ore, unless you're very bullish on the spot price of the commodity, now isn't the time to buy its shares. With Australia's Bureau of Resource and Energy Economics, Goldman Sachs and many other prominent forecasters suggesting lower iron ore prices could be here to stay, I advise investors to adopt a wait and see approach to the iron ore sector in general. In the meantime there's plenty of other resources stocks available at great prices.
