Down 7.5% over the past 12 months, shares of Rio Tinto Limited (ASX: RIO) have held up quite well considering…
…how far iron ore prices have fallen …
…the reduction in copper prices…
…the likelihood of a slowdown in the Chinese economy…
…and the oversupply of coal.
From a pricing perspective, the following commodity price indices chart from The International Monetary Fund sums it up nicely…
The IMF's index includes copper, aluminium, iron ore, tin, nickel, zinc, lead, and uranium prices.
So what?
To me, that graph says the latest falls in commodity prices more broadly cannot be explained by supply pressures – it's a demand problem.
For Rio, which generates 46% of revenues from iron ore, ongoing spot price falls are going to have a profound effect on its bottom line (profit). Even if it doesn't go bust, it's still not a good thing to have prices falling.
Now, some financial commentators are suggesting iron ore could rebound. To me, that seems absurd. For those unaware, iron ore is a steel-making ingredient.
As the chart above shows, iron ore traded at, slightly above or below $US15 per tonne from 1985 through to 2004.
Its price exploded as China began its unprecedented infrastructure-led economic boom.
To put China's boom into perspective, between 2011 and 2013 alone it used more cement than the U.S. did between 1901 and 2000 – the entire last century!
Can this type of demand go on forever? I don't think so.
Iron ore, like cement, is different from petrol or gas. It isn't consumed on a day-to-day basis.
And as the Australian government's Office of the Chief Economist wrote in its March Resources and Energy Quarterly report, "After a decade of growth driven primarily by fixed asset investment the Chinese Government is planning to rebalance the economy, through market reforms, to increase domestic consumption."
In 2014 China exported 94 million tonnes of steel — up 50% year over year — because of lower consumption growth and increased supply.
Emerging economies such as India, Indonesia or Thailand could pick up the slack but I doubt it.
In addition, some market commentators suggest the recent plunge in iron ore prices will force high-cost producers from the market and supply prices will stabilise.
So far, Australia's Atlas Iron Limited (ASX: AGO) is the only noteworthy producer to have shown signs of flinching.
-My personal opinion is we're still far away from that happening.
Indeed, many companies will be able to sustain losses at the corporate level for a long period of time, so long as their mines remain cash flow positive.
Foolish takeaway
Rio Tinto might not go 'bust' under a much lower commodity price environment. However if – as expected – China's demand for raw materials continues to wane, I'm not waiting around to find out what happens.
