In recent years, any year eight economics student could have looked at a graph of iron ore supply and demand and predicted lower prices.
It's a rather simple equation: If demand drops and supply increases. Expect tears.
Iron ore – a key ingredient in the manufacture of steel – has fallen from $US135 per tonne at the beginning of 2014 to around $US80 per tonne today.
Over the weekend BlueScope Steel (ASX: BSL) CEO, Paul O'Malley, was quoted in the Fairfax press as follows: "I've been saying for a couple of years that I think China has reached peak steel intensity."
And he's not alone, analysts from a number of high profile investment banks have forecast lower prices for many years. The Motley Fool's Investment Advisor Scott Phillips wrote of an iron ore bubble back in 2012.
With the most recent price falls, the financial media and investors are being quick to blame iron ore majors such as Vale SA (ADR) (NYSE: VALE), BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) as being proponents of lower prices, by significantly ramping up their iron ore output.
Once again, any year eight economics student will tell you it's a competitive industry and prices will always move back towards equilibrium. If the big miners don't increase their production, someone else will. Indeed, iron ore accounts for 5% of the earth's crust, so it's not exactly hard to come by.
Anyone who can dig it up, crush it and deliver it to China for less than their total cost of production, can make money. Of course, it's a bit more complicated than that, but you get the gist.
Costs are paramount. And for our biggest miners to be able to produce iron ore for the less than $US50 per tonne is the result of almost unimaginable supply chain technology, infrastructure and automation. Ore quality also plays a big part in determining project feasibility as well as production costs and is one reason Fortescue Metals Group Limited's (ASX: FMG) margins are likely under threat in the current low price environment.
Brazilian giant Vale is the world's biggest producer and has the lowest cash costs. Fortunately, the two large Australian producers, Rio and BHP, have a breakeven cost advantage over Vale, with estimated per tonne prices well below $US55.
This is due to their geographical advantage.
It's a much longer journey for Vale's product to get to China than it is for Rio's or BHP's. In 2012 the Brazilian ambassador to Australia told The Australian Financial Review it took around six weeks for Vale ships to reach China, whereas those from the Pilbara would do it in just nine days.
At the time, transport costs were estimated to be $US8 per tonne and $US20 per tonne for Pilbara versus Brazil, respectively. However with Chinese port authority bans practically lifted on Vale's huge Valemax ships, it appears the South American miner's costs will now be meaningfully improved.
Buy, Hold, or Sell?
In today's price environment, picking up shares in high-cost iron ore miners for a 'quick buck' is akin to picking up pennies in front a of steamroller. At the very max, only the top four producers should be atop Foolish investors' watchlists.
My advice to risk averse investors would be to avoid iron ore miners altogether, or buy the most diversified producer, BHP Billiton. In addition I think Rio is a better buy than Vale.
