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Could our iron ore majors follow the Santos Ltd (ASX: STO) share price crash?

The next group of stocks that could suffer a painful crash that’s a kin to what we are experiencing in the energy sector are our iron ore majors.

The BHP Billiton Limited (ASX: BHP) share price and Rio Tinto Limited (ASX: RIO) share price have crashed around 3% each in morning trade while Fortescue Metals Group Limited’s (ASX: FMG) share price had shed a more modest 1.8% to $3.94.

I am not surprised to see Fortescue hold up better and I’ll explain why later in the article.

The drop in the miners coincides with another risk-off day on our market with the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) giving up 0.5% of its value.

It’s not the miners but the oil stocks that are copping a bigger beating as the crude price tumbled to a one-year low on Friday (click here to read more about the market impact from the oil slide).

Our energy stocks are the worst performers over the past month with the sector burning up close to 7% of its value while the mining-heavy materials sector is down around 2%.

Iron ore to follow the oil plunge?

But there are growing fears that our mining giants will soon follow the same downward spiral of Santos Ltd’s (ASX: STO) share price and Woodside Petroleum Limited’s (ASX: WPL) share price as the iron ore price fell to around a one-month low late last week.

What’s driving the iron ore price lower is the profit margin squeeze by iron ore-consuming steel mills in China.

These mills are believed to be making next to no profit at the moment, according to a report on Business Insider that quotes Commonwealth Bank of Australia (ASX: CBA) analysts.

The speed of which margins in the steel making sector have collapsed raises questions on whether the trend can be arrested as previous attempts to improve industry profitability by closing underperforming mills seem to have failed.

Fortescue – from ugly duckling to swan

Interestingly, it’s the price of higher-grade iron ore from BHP and Rio Tinto that have fallen harder. This is in part because the higher quality ore has shot up a lot faster, but that’ not the only reason.

If steel mills are fighting to survive, they will favour the cheaper ore from Fortescue as they prioritise short-term profits over improved efficiency.

This adds to my view that the discount between high-grade and low-grade ore will continue to narrow over the coming weeks and will revert to the mean after blowing out for most of 2018.

Time to sell BHP and Rio Tinto?

On the other hand, this doesn’t mean you should ditch our mining giants. I believe that fiscal stimulus through infrastructure construction in China will provide a floor for the iron ore price.

Some sceptics will say that the Chinese government is already embarking on such a building program and that isn’t stopping the price of iron ore from falling.

But I believe that China will step up this program, particularly as the US-China trade war starts to bite harder on the Chinese economy.

I remain overweight on the sector.

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Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited, Fortescue Metals Group 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 Scott Phillips.

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