Why the Fortescue Metals share price is down today

Fortescue Metals Group Limited (ASX: FMG) has seen its share price sink 5.7% to $1.73 today, after investment bank Goldman Sachs took a red pen to its iron ore forecasts over the next three years.

The bank is predicting the iron ore price will remain under US$40 a tonne for the next three years, mainly due to a slowdown in China. Iron ore is expected to average US$38 a tonne in 2016 and US$35 in 2017 and 2018, around 13% lower than its previous forecast.

Goldman says it expects mine closure to accelerate next year, as the health of China’s steel industry falters. There’s a current glut of steel globally, and many steel mills are already operating at a loss. China’s Shanghai Baosteel Group chairman Xu Lejiang expects output to contract by as much as 20%, matching the experience seen previously in other steel industries including the US and Japan.

Chinese steel output is forecast to fall to around 783 million tons in 2016, down from 806 million tons in 2015, according to the China Iron & Steel Association, and could fall even lower. That’s well below the more than 1 billion tonnes BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) had been forecasting for some time.

BHP recently cut its China peak production forecast to between 935 and 985 million tons, while rival Rio is still forecasting China to produce more than 1 billion tons of steel by 2030.

Goldman Sachs says its sees China’s iron ore demand by 2040 halving, as steel production falls to below 600 million tonnes.

Falling steel production will drive lower demand for iron ore, while, at the same time, massive new iron ore mines like Gina Rinehart’s Roy Hill mine come on stream. Roy Hill shipped its first ore a week ago and is ramping up to produce 55 million tonnes within 18 months at full capacity, but it’s not the only producer adding production as I illustrated here.

Iron ore prices recently slipped below US$40 a tonne, falling as low as US$38.30 a week ago – the lowest level since May 2009 according to the Australian Financial Review.

Fortescue is seen as the weakest link by many analysts, with the greatest to lose as iron ore prices fall, hence the 5.7% fall in the share price today. The only problem is that Fortescue has halved its production costs in the past year or so, while increasing the quality of its ore and thereby reducing the discount it received from the benchmark 62% iron ore price. The iron ore miner also believes it has cash costs of production within a whisker of that by the market leaders, BHP & Rio and ahead of Brazil’s Vale.

Vale is reportedly struggling to breakeven at prices under US$40 a tonne but is still attempting to increase output and lower its production costs to around US$11 a tonne.

Fortescue still has no control over the commodity price, so if it continues to fall further, the company will again need to find more ways to cut costs. One way will be through the arrival of the first of its special-purpose ore carriers due to arrive late next year.

Foolish takeaway

We’ve already seen BC Iron Limited (ASX: BCI) cease operations at its Nullagine JV with Fortescue, and other mines can’t be that far away either. Fortescue says its breakeven price will be US$36 a tonne, but you can probably expect that to come down even further.

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Motley Fool writer/analyst 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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