A Further Decline in Iron Ore Prices Could Doom These Stocks

Prices for iron ore, a raw commodity used to make steel, fell below $100 a ton earlier this week for the first time in nearly two years amid growing concerns over a slowing Chinese economy. But given the deteriorating global supply and demand fundamentals for the commodity, the worst may be yet to come.

According to estimates by Goldman Sachs, the price of iron ore could plunge to $80 a ton by next year, which could have potentially grave consequences for a number of large producers, including Vale , Cliffs Natural Resources , and Fortescue Metals Group Limited .

An iron ore mine in Western Australia. Photo Credit: Wikimedia Commons

The bear case for iron ore
The case for an iron ore bear market is predicated upon two factors: decelerating steel demand from China, which consumes roughly two-thirds of global seaborne iron ore, and an oversupply of the commodity from increased output from large mining companies.

Chinese steel demand is likely to fall for one key reason. The nation urgently needs to rebalance its economy away from fixed-asset investment-led growth and toward more sustainable domestic consumption-led growth. Achieving this rebalancing would necessarily reduce Chinese demand for raw materials such as iron ore, thereby lowering the steel intensity of its economy over the next few years.

Further, as Goldman Sachs' analysts note, Chinese steel-making capacity is near its peak, as increasing environmental pressures force the closure of more blast furnaces in the country, which suggests that Chinese steel demand will decelerate. According to some estimates, up to 150 million tons of high-cost finished iron ore production in China has been shut off already or is about to be shut off.

Meanwhile, strong growth in iron ore supplies will exert additional downward pressure on prices. Citigroup predicts that the global seaborne iron ore surplus may surge to 67 million tons this year, as compared to just 2 million tons last year. Based on the combination of weakening Chinese demand and rising global output, Goldman Sachs' analysts predict that iron ore prices will average $108 a ton this year and fall to $80 a ton in 2015.

Stocks to avoid
If their forecast pans out, as I expect it very well could, it would be especially bad news for Vale, the world's largest iron ore producer. The Brazilian mining giant is even more heavily exposed to iron ore than peers BHP Billiton and Rio Tinto , with iron ore accounting for 94% of its full-year 2013 EBITDA, as compared to 52% for BHP and 77% for Rio Tinto.

Though Vale enjoys the advantage of being the lowest-cost iron ore producer, it still isn't immune to a rapid and prolonged slump in the commodity's price. According to an analysis by Barclays, just a 10% reduction in the price of iron ore would reduce Vale's 2014 earnings by 32% and cut its net present value by nearly half. A 25% decline, as Goldman predicts, could greatly constrain profitability, despite the company's recent cost cutting measures.

Cliffs Natural Resources, the largest U.S. producer of iron ore, also has significant exposure to iron ore prices, with about three-quarters of its revenues dependent on the commodity. As a relatively high-cost iron ore supplier, Cliffs has taken a big hit from lower prices this year, swinging to a net loss of $83 million in the first quarter.

Though Cliffs' management has reduced its planned capital spending by about 25% this year in response to lower prices, a sharp and prolonged decline in iron ore prices would drastically reduce Cliffs' profitability, given the company's higher-than-average cash costs of roughly $85-$90 per ton at its Canadian mines, $65-$70 per ton at its U.S. mines, and $60-$65 per ton in Australia.

Lastly, Australia's Fortescue, the fourth-largest iron ore exporter in the world, is another iron ore-levered stock to avoid. Of all the large producers, it is by far the most exposed, with the steel-making commodity accounting for nearly 98% of its operating revenue last year. The company's margins are also significantly lower than those of BHP Billiton, Rio Tinto, and Vale because of its relatively high operating costs and lower-quality product.

Fortescue also sells the vast majority of its product to China, leaving it especially exposed to a slowdown in that nation's steel demand, and is highly leveraged, with a net debt position of US$7.7 billion as of the end of March. While it has paid down about US$3.1 billion in debt, the cash flows needed to continue reducing debt and achieve its gearing target of 40% are predicated upon high iron ore prices. If prices fall to $80 per ton next year, the company could find itself in dire financial straits.

Investor takeaway
Based on the view that China must reduce the fixed-asset investment share of its GDP if it is to achieve sustainable growth, I think iron ore and certain other hard commodities could be in for a sustained bear market. While prices will no doubt fluctuate over the rest of the year and could even rise if China expands credit, the long-term trend is decidedly bearish. As such, I would generally steer clear of the iron ore-levered companies mentioned here, unless they become excessively undervalued.

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The article A Further Decline in Iron Ore Prices Could Doom These Stocks originally appeared on Fool.com.

Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs and owns shares of Citigroup and Vale. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

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