Lex is a premium daily commentary service from the Financial Times. It helps readers make better investment decisions by highlighting key emerging risks and opportunities.
Iron ore prices: how low can they go? This is the big question on every iron ore miner's chapped lips right now. Australia's official commodities forecasting agency said on Wednesday in its latest quarterly report that prices could fall to $90 (U.S.) a tonne over the next five years. That is a lot lower than the $134 they are today. Little wonder investors are dropping mining stocks such as Vale, BHP Billiton and Rio Tinto. Their shares are down this year by an average one-sixth.
For Rio Tinto, the iron ore price is especially important – the miner derives almost three-quarters of its earnings before interest, tax, depreciation and amortization from the mineral. And the 23-per-cent fall in the average price of iron ore to $128 in 2012 caused 60 per cent of the $6-billion fall in Rio's profit.
Granted, cash costs are very low – Rio and BHP Billiton can deliver iron ore to China at below $50 – and could fall a little more as capacity increases. But earnings expectations will still have to be tempered. Bernstein estimates that if average iron ore prices fall $10 below its $137 forecast this year, Rio's earnings per share will fall by 10 per cent (assuming all other metal prices and production stay the same).
As for demand, it is not falling off a cliff. China's steel mills have cleared a lot of the excess capacity built up last year. And construction is recovering. But the growth in Chinese infrastructure development will probably be more steady in the coming years following the fits and starts that surrounded the 2009 financial stimulus. The problem, therefore, looks to be on the supply side.
The big three miners make up about two-fifths of total iron ore production. Yet they, including Fortescue, are planning to add a further 235 million tonnes in capacity by 2015, which is almost equal to all of Rio's output in 2012. If prices do fall substantially, Chinese urbanization will be the biggest beneficiary. But is that in the interest of investors in the world's biggest iron ore miners?