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Could iron ore prices fall to US$20-US$30 a tonne?

wind headwinds

Thanks to some savage cost cutting, some savvy business deals with contractors and the falling Australian dollar, Australia’s junior iron ore miners appear to be generating positive cash flows.

Atlas Iron Limited (ASX: AGO), BC Iron Limited (ASX: BCI), Arrium Limited (ASX: ARI), Mount Gibson Iron Limited (ASX: MGX) have all managed to cut their production costs significantly in the past three years.

Prior to 2013, iron ore miners hardly mentioned their production costs – not surprisingly when they were receiving US$130 a tonne and higher for their product. Even with the Australian dollar trading above parity with the US dollar (~$1.03), the miners were making a motza.

Looking through their quarterly reports, most were focused on ramping up production. Back in November 2011 (PDF), Atlas was even aiming for production of 46 million tonnes per annum in 2017. The miner produced 12.2 million tonnes in the 2015 financial year and appears unlikely to achieve its target.

Downward pressure arrives

But the dramatic fall in the iron ore price that started in 2011 saw the commodity price plunge from above US$180 a tonne down to the current price of around US$52 a tonne. The falling price was due to a couple of reasons. Iron ore miners around the world had rushed to open new production – at virtually any cost – to take advantage of the high prices in 2010 and 2011. That saw massive amounts of supply come on stream.

Chinese steel producers losing money

At the same time, growth in the production of steel – of which iron ore is a major component – had slowed. Chinese steel production grew just 4% in 2012, after a number of solid years of double-digit growth. Steel demand had waned too, impacting on steel prices, pushing them lower. The Nikkei Asian Review said today that a tonne of Chinese steel is cheaper than a tonne of cabbage.

Forbes estimates that the majority of Chinese steel makers are currently loss-making, but very few mills have even considered cutting production, let alone closing. In an effort to make at least some money, Chinese exports of steel have rocketed higher, up 26% this year compared to last year.

China’s steel output is falling, albeit slowly – down just 2% in the first eight months of 2015. Earlier this week, South Korea’s biggest steelmaker, Posco, reported a quarterly loss of US$582 million.

Steel production peaked?

In April this year, economist Ross Garnaut predicted that China’s steel production had peaked, and will fall by more than 25% over the next 15 years to around 600 million tonnes in 2030. BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) estimate it will be around 1 billion tonnes.

The chairman of China’s second-largest steel producer, Shanghai Baosteel Group, Xu Lejiang told Bloomberg overnight that the loss for China’s steel industry totalled $2.8 billion in the first eight months of the year. Output may eventually fall by 20%, matching the experience seen in the US and other countries he said.

China’s steel producers are also feeling the pain from another front. Banks are tightening their lending to the steel sector, including for raw material stockpiles (which includes iron ore).

Supply versus demand

The problem Australia’s junior iron ore miners face is that supply is still coming on stream, as we illustrated here. Other sources estimate around 200 million tonnes of excess supply will be added in 2016 – much of it at very low cost. When you have steel production declining but iron ore production is rising, simple economics suggests it can only result in one thing – a lower iron ore price.

Foolish takeaway

For 20 years up to 2004, when China’s steel production took off, iron ore had traded consistently below US$20 a tonne. Australia’s big miners can ship the stuff to China at around those prices now, so it would take the iron ore price to halve from here to cause them major issues – but it would be game over for the junior miners.

Predictions of an iron ore price near US$40 a tonne early next year appear optimistic in my book. It wouldn’t surprise me to see iron ore prices drop to the US$20-US$30 per tonne range within the next year or so.

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Motley Fool contributor Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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