Why Long-Term Investors in Big Miners Shouldn't Worry About Lower Iron Ore Prices

Alphonzo Desade  |

iron ore prices have plunged. Given the significant contribution iron ore makes to these companies’ top-line, one can expect a significant impact on cash flows as iron ore price trade at around $90 a ton. For investors in big mining companies, this is a major concern as it threatens shareholder distributions. But, they shouldn’t really be worried if they are long-term investors as lower iron ore prices will eventually benefit mining giants.

Iron ore was the best performing commodity in 2013. Indeed, robust iron ore prices boosted the results of mining giants, who have been offloading non-core assets and focusing on core businesses such as iron ore. In fact, strong iron ore prices even gave miners the confidence to bring down their debt levels and boost shareholder payout. However, their plans have been negatively impacted by a sharp drop in iron ore prices this year.

Since the start of this year, iron ore prices have remained under pressure amid concerns that demand in China will weaken as the world’s second-largest economy rebalances. China is the world’s largest consumer of iron ore. While weakening demand is a worry, what has really hurt iron ore prices is concern over a supply glut.

In previous years, demand exceeded supply in the iron ore market on a consistent basis. This led to miners’ ramping up their production. And now that miners are ready to bring new production online, China is seeing a slowdown. As a result, there is likely to be a supply surplus in the iron ore market for the first time in many years. This has had a significant impact on iron ore prices and the outlook for miners.

Weaker iron ore prices will certainly hurt miners’ cash flows even if they remain profitable. The likes of BHP Billiton and Rio Tinto have production costs of around $45 per ton, therefore if iron ore prices were to fall to around $80 per ton as most analysts now expect, these companies will remain profitable. However, their margins will be shrunk and if the decline in prices is not offset by an increase volume, we can expect a negative impact on their cash flows. The increase in volume looks unlikely, at least in the near-term, as China experiences a slowdown. As a result, the outlook for major mining companies is bearish in the near-term. However, if you are a long-term investor, you should not worry as miners will eventually benefit from weaker iron ore prices.

Indeed, major mining companies will benefit from weaker iron ore prices in the long-term. This is because at the current price level many of the smaller mining companies in Australia will struggle to survive. In addition, weaker iron ore prices will also force shutdown of high cost mines in China.

According to consultancy firm Wood Mackenzie, sharp fall in iron ore prices could force China to cut around 80 million tons of mine capacity, which is around a fifth of China’s net annual output. Andre Hodge, analyst at Wood Mackenzie, believes that closure of mines will benefit BHP Billiton, Rio Tinto and Vale. This is because the domestic production will be replaced by imported iron ore and given that only the likes of BHP, Rio and Vale can sustain weaker iron ore prices.

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