What lies ahead for the iron ore industry?
Iron ore quality has been deteriorating, especially since 2003, mainly because of the supply response to fast growing Chinese demand. The Chinese steel industry is getting consolidated with newer and bigger blast furnaces which will require a high quality of iron ore. As a result, this would lead to higher premiums for high quality ore and a favorable environment for high-quality pellet producers.
Changing steel drivers
While China will remain volatile as one of the key engines of demand for iron ore.
However, due to the policy shift from investment to consumption, the steel drivers would change. Automobiles, high end equipment manufacturing, bio-technology, new energy, and next generation IT will contribute more towards steel demand.
Prices for iron ore have already decreased. They’re down 30% from the prices at the start of the year, mainly because of the excess supply situation. This isn’t going to get better anytime soon. Supply glut to the extent of 150 million ton (or MT) for 2015 and 250 million ton for 2016, will be very difficult to absorb at the current market rate. This would end the era of supernormal profits for iron ore players and would result in mine closures. Some of the high cost Chinese domestic capacity should go offline. However, there’s a caveat, many mills in China are captives or state owned enterprises (or SOEs), and they’ll be much stickier.
Quality will remain the key
Low cost and high-quality producers like Rio Tinto (RIO), BHP Billiton (BHP), and Vale (VALE) will be the net beneficiaries of the structural demand growth from China, India, and other developing economies. These three players are already adding low-cost supply to the market which will crowd out the high-cost producers. However, with their financial strength, they can easily weather more price pressure. Ultimately, their earnings and stock prices will positively benefit from the situation. However, companies with lower grade like Cliffs Natural Resources (CLF) would suffer until prices remain under pressure. These companies form close to 18% of the iShares S&P Global Materials Sector Index Fund (MXI).