Why iron ore stocks could underperform in the short-term before bouncing in 2018

The share prices in our best loved iron ore stocks like BHP Billiton Limited (ASX: BHP), Rio Tinto Limited (ASX: RIO) and Fortescue Metals Group Limited (ASX: FMG) are likely to be dragged lower today and it won’t only be due to a drop in iron ore futures.

The steel-making commodity suffered a 7.5% drop on the Dalian Commodity Exchange yesterday to RMB494.5 (US$74.77) on expectations of waning demand for steel in China as winter kicks in.

This is a seasonally weak period for the commodity and that will cast a shadow over our large miners although I am still anticipating the sector to outperform in 2018.

However, it isn’t only seasonal weakness in the iron ore market that will weigh on sentiment over the short-term. Brazilian iron ore giant Vale SA (ADR) (NYSE: VALE) has vowed to sell 25 million extra tonnes of the material in 2018.

That equates to around a 7% increase in Vale’s annual production output to circa 390 million tonnes and marks the most aggressive ramp up in production since Vale started its S11D expansion, according to a news report by Fairfax Media Limited (ASX: FXJ).

It is worth watching what Vale will do over the next few years as well as the miner could have an impact on the price of iron ore. Management indicated it will not exceed 400 million tonnes of production before 2023, if not beyond.

However, that is predicated on the price of iron ore not rising too strongly with Vale forecasting the price of the commodity to range between US$55 and US$65 a tonne in the 2018 financial year.

This follows recent commentary by Rio Tinto that they are not looking to drive up the supply of iron ore.

The silver lining from Vale’s commentary is that the market was expecting the miner to export 459 million tonnes of iron ore by 2019. That would have flooded the market and driven down prices for the commodity.

That wouldn’t have been good for Vale or any of its Australian-listed peers but Vale also acknowledged that high prices are bad for the industry. The miner has 50 million tonnes of excess capacity that it can use to “balance the market” if necessary.

If iron ore averages around the US$60 a tonne mark, that would actually be a good outcome for BHP and Rio Tinto as they can still generate a lot of free cash at those prices. Fortescue could be more at risk as it produces lower quality ore that sells at a hefty discount, although Fortescue is trying to produce higher quality ore to overcome this issue.

For this reason, I will look at the share price weakness over the next week or two as an opportunity to top up my holdings in Rio Tinto and BHP.

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Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited and Rio Tinto Ltd. 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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