This investment bank thinks the iron ore rout will get a lot worse

This is bad news for BHP Billiton Limited (ASX:BHP) and Rio Tinto Limited (ASX:RIO).

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Investors in the iron ore sector may be feeling somewhat encouraged after the iron ore price rose again overnight, climbing 0.6% to US$39.43 a tonne, according to The Metal Bulletin.

Before they get their hopes up however, it’d be worth noting that Goldman Sachs has just downgraded its guidance for the commodity, and expects it to remain below US$40 a tonne, on average, for the next three years.

Indeed, according to The Australian Financial Review this morning, the investment bank thinks iron ore will trade at just US$38 a metric tonne next year, and then US$35 a tonne in both 2017 and 2018. It’s also worth pointing out that those are forecasts for its average price, suggesting it could fall below those levels – others have suggested it could fall below US$30 at some point in the near future.

At its current price tag, iron ore is worth more than 70% less than it was at the beginning of the 2014 calendar year when it was fetching roughly US$135 a tonne. Back in 2011, a tonne of the steelmaking ingredient cost north of US$180.

Since then however, the commodity’s value has plummeted as a result of excess production from the world’s biggest miners, combined with a sharp downturn in the rate of growth of China’s economy. The AFR also referred to Goldman Sachs’ suggestion that by 2040, China’s iron ore demand may contract by 50% as steel consumption drops, and greater recycling efforts see more scrap metals being used instead.

This is particularly bad news for a number of Australia’s smaller miners, most of which run higher-cost operations and produce lower quality ore. A weak Australian dollar will support them to some degree but companies like Arrium Limited (ASX: ARI), Mount Gibson Iron Limited (ASX: MGX) and BC Iron Limited (ASX: BCI) are amongst those most at risk.

Although the majors maintain lower cost operations, lower iron ore prices will still constrict their margins which could put a real squeeze on earnings, and perhaps even dividends. The share prices of BHP Billiton Limited (ASX: BHP), Rio Tinto Limited (ASX: RIO) and Fortescue Metals Group Limited (ASX: FMG) have fallen heavily this year, but they still present as risky investment prospects today.

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Motley Fool contributor Ryan Newman has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. You can follow Ryan on Twitter @ASXvalueinvest. 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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