The Victims of Iron Ore at US$39

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Following months of speculation, the price of iron ore finally dipped below the US$40 mark overnight. The commodity was trading down 2%, selling for US$39.06 a tonne at Qingdao port in China.

This isn’t just a psychological blow to the industry. If prices remain in the 30s, it could prove fatal for high cost producers. Of the 11 largest iron ore producers, seven have break even costs above US$39. An eighth one, Fortescue [ASX:FMG], matches the price point with a breakeven costs of US$39 a tonne.

Should low prices persist, it’s hard seeing how some of the smaller players could survive. Arrium [ASX:ARI] and Atlas Iron [ASX:AGO] are a particular concern. But you could add any of the smaller producers to that list. BC Iron, Grange Resources, Mount Gibson, and Anglo American all have relatively high break even costs. The only safe bets remain BHP Billiton [ASX:BHP] and Rio Tinto [ASX:RIO] from an Aussie perspective.

If prices were to stay in the 30s, then we should expect some closures. With breakeven costs dollars above the price point, something would have to give. However it’s likely these low prices would have to persist well into next year for that to happen.

The price of iron ore has ranged in the US$40–45 band for several months. Up to now, the smaller producers have managed to stay afloat. But they’ve done so because breakeven costs were in line with prices. That’s true of Arrium, Atlas and Mount Gibson Iron. Arrium, for instance, breaks even at US$43. But it’s breakeven is now US$4 above current prices.

In any case, a sustained US$30 range trading price point will put a lot of pressure on miners. The only question unanswered is whether or not these prices will actually persist. If so, for how long? That’s harder to predict. And the jury remains split.

Some analysts see a quick rebound back into the $40 a tonne range. Others feel weak Chinese demand will drag well into 2016.

Yet that’s only one consideration traders are weighing up. The fate of the US dollar will also factor into future prices. Iron ore is priced in US dollars. And any major change in the value of the greenback will affect iron ore prices too. Which is why producers are watching the Federal Reserve like a hawk. The US dollar could surge as early as next week, when the Fed convenes to decide on interest rates.

Chinese iron ore stockpiles to determine prices in 2016            

In the short term, however, China remains the biggest influence on prices.

ANZ expects the commodity to face further price pressure as we head into Q1 2016. The Australian Financial Review reports:

‘[According to ANZ] the Chinese placed orders for iron ore in the fourth quarter, stockpiling it in the first quarter for steel production after the holidays finished. Consequently, there were fewer iron ore orders placed in the first quarter and demand was traditionally weak. That would especially be the case this year.

‘[On the closure of Chinese steel mills]…Past the Chinese New Year there’s likely to be a number of bankruptcies. There’s likely to be a number of steel mills that will go under. This will be the shake-up the industry is looking for. It’s probably going to happen in the first quarter, possibly the second quarter.’

Should Chinese steel mills face closure, the effect on the industry would be mixed. Demand would dampen, hurting gross iron ore revenues. And it’d force iron ore producers to cut back on supply.

That may take place one way or another. Low cost producers like BHP and Rio will know that current prices are already squeezing smaller producers. If it leads to some miners going bust, they could cut back on their aggressive market share strategies.

But anyway, that’s where ANZ sees things going. Not everyone however is convinced the Chinese will stockpile much iron ore this quarter.

UBS believe Chinese mills are already under enough pressure as is. Stockpiling even more iron ore, it says, would be costly for steel mills. They’d have fewer reasons to spend money on expanding capacity. Particularly when steel prices remain as weak as they are. Buying iron ore might be cheap, but it counts for little if steel mills are losing money.

If that’s the case, Chinese stockpiles of iron ore would’ve been seasonally low this quarter. And if that’s true, iron ore demand should revert back to normal in Q1 2016. The fact that prices have fallen to US$39 does suggest that stockpiling was weak this quarter. How?

Prices are influenced by demand. And any fall in prices should indicate a drop in demand as well. If that’s how the next three months play out, then iron ore prices are likely to edge back above the US$40 mark. And, more than mere symbolism, it would ease a lot of pressure on higher cost producers.

Who survives the iron ore price glut?

Nonetheless, the future for the industry remains bleak. At US$30 a tonne, we’ve reached a symbolic crossing point. It leaves only BHP Billiton, Rio Tinto, and Brazil’s Vale [NYSE:VALE] well below breakeven costs. Fortescue just makes the cut, with prices matching Fortescue’s breakeven costs.

The only thing we can say with any certainty is that BHP, Rio and Vale will survive the ongoing price rout. Everyone else has a guillotine over their heads.

Wherever things go, the US$39 price point caps off a miserable few years for the industry. Iron ore has lost 80% of its price since 2011. Back then, it was trading at US$190 a tonne. At US$39, the commodity is back to trading at levels last seen before the mining boom took off in 2005. And it’s symbolic of the decade long boom to bust that’s now come full circle.

It may turn out that iron ore prices don’t recover for several years. It would be catastrophic for the industry, but it might be necessary.

That’s not to say the commodity price rout is here to stay though. Investment guru Rick Rule believes there are three commodities which are set to explode in the next few years. And it could herald the start of a new cycle of commodity driven growth.

Rick is the founder of Sprott Global Resource Investments, one of the world’s leading resource investment firms. He’s witnessed several cycles come and go in his 40 year career.

His experience gives him a knack for spotting companies that are poised to flourish before commodity cycles booms.

Rick’s put together a free video, revealing his top three commodities. In it, he’ll show you how to identify the companies that can boost your portfolio as this new cycle booms. To find out how to watch the free special report, click here.

Mat Spasic,

Junior Analyst, The Daily Reckoning

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