Big Winners and Big Opportunities in Iron Ore

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While the U.S. is fixated on whether Congress will shoot the country in the foot, a few giant companies on the other side of the world are raking in the profits. Times are so good for the iron ore industry that the industry's results are carrying Australia's 3% GDP growth. There are big winners and big losers in this market, but the best opportunities aren't where you'd think. Read on and I'll explain why a few small companies are better for your portfolio than any of the large mining giants.

The winners
As the worldwide economy has recovered from the debt crisis of 2008, demand for iron ore from steelmakers in China has surged. Since supply is relatively constrained in the short term -- it takes years for new iron ore mines to be built -- iron ore prices have jumped roughly threefold since 2008. This is enough on its own to send miners' profits soaring, and it has.

This morning, Vale (NAS: VALE) reported a 74% surge in second-quarter net income, which was below analyst expectations, to $6.45 billion from a year ago. Rio Tinto (NYS: RIO) reports Aug. 4, while you have to wait until the end of August to see BHP Billiton's (NYS: BHP) earnings

There is a second factor that has played into miners' booming profits.

The losers
In 2008, shippers were making money hand over fist as there was a shortage of ships to move iron ore and other goods. Shippers were charging rates that peaked at $234,000 a day for a Capesize vessel, which carries roughly 80,000 to 175,000 dead weight tons (DWT). Many companies rushed to build ships. This had its expected effect; the past two years saw the Capesize fleet grow 39 percent, to 1,115 vessels.

Now there's an oversupply of ships and rates are at their lowest levels in years. A Capesize costs just $11,314 a day to charter, a 95% drop from three years ago and below most companies' breakeven points. Shipping costs now take up just 10% of the value of iron ore, down from a high of 64% in 2003. This has increased miners' profits as lower shipping costs mean more money from sales goes straight into their pockets. It's a dream come true for iron ore miners, the highest prices in years with the lowest freight prices.

However, it's a nightmare for shippers. Currently the spare carrying capacity of the Capesize fleet is roughly 25%. The nightmare is going to get worse. There are still more ships being built. IHS Fairplay estimates new orders are equal to 36% of existing capacity. The only way this makes sense is that companies like Dryships (NAS: DRYS) and Vale are investing in new very large ore carriers (VLOCs), which carry two to four times as much as a Capesize or anywhere from 200,000 to 400,000 DWT. Older, smaller, and less-efficient ships will be scrapped for the new behemoths that will rule the iron ore trade.

Where to invest?
After that diatribe you'd probably expect me to recommend a mining company, right? Wrong.

Remember the secret to commodities investing:

The time to own commodities is when they are down, when everybody has lost money in them, and when they trade below the cost of production.

In times like this you should be looking for value among the shippers rather than the mining companies. The reason is that when a commodity is unprofitable for the companies that provide it, high-cost providers die off or halt operations. This is true whether we are talking about shipping, iron ore, natural gas, or ethanol. The industry shrinks as the weakest firms die off. This time is marked by large amounts of turmoil, falling stock prices, and occasionally bankruptcies before supplies decline and prices rise again. The companies that do survive thrive as the industry begins to do better, and that's where the best profits can be made.

What do I like now?
While DryShips is intriguing, unless you are willing to take a huge gamble, I'd avoid it. While the company will survive, shareholders might see more massive dilution before it thrives once again.

The stock I like most is Diana Shipping (NYS: DSX) . The company has one of the strongest management teams in the industry, who were sounding alarm bells as far back as 2009. Unlike most of its competitors, Diana Shipping used long-term contracts to lock in rates almost three times as high as the current rate. The company is one of the least levered in the industry, with current assets roughly equal to liabilities, and is the most likely to survive intact. Diana's strong balance sheet is an undervalued asset it can use to buy up ships on the cheap as competitors struggle.

And struggle they will. As a recent Goldman Sachs report noted, the shipping business is getting tougher with faster growing supply and less demand for shipping in the first quarter than expected. Highly leveraged operators such as Eagle Bulk Shipping (NAS: EGLE) and Excel Maritime (NYS: EXM) are going to be fighting for their lives. I'd rather take the safe bet that will work out well over the long run than possibly risk a complete loss of capital on a stock teetering on the edge of the bankruptcy cliff.

Foolish bottom line
When looking to invest in a commodity, focus on commodities trading below the cost of production, and over time you should be duly rewarded. Looking for more ideas? Check out The Motley Fool's free report "The Only Energy Stock You'll Ever Need." Just click here to grab a copy.

At the time this article was published Fool contributorDan Dzombak's musings and articles he finds interesting can be found on his Twitter account:@DanDzombak. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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