If you thought the worst of the iron ore rout is behind us and that the market will make a steady recovery into 2018, you shouldn't read the latest report from Citigroup. The broker is tipping more pain as the price of the steel making ingredient is forecast to fall even further over the next year and a half.
The price of iron ore (62% Fe) has fallen from near US$90 a tonne in February this year to around US$55 a tonne where it appears to be finding a floor. This has prompted some to believe that the commodity is forming a base on which to build on.
That would be good news for our largest listed iron ore producers such as Rio Tinto Limited (ASX: RIO), BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG). These stocks have been performing strongly over the past year with Rio Tinto up 38%, BHP up 27% and Fortescue up around 47%.
In contrast, the S&P/ASX 200 (Index:^AXJO)(ASX:XJO) has only managed to deliver a modest 12% increase.
But Citigroup is forecasting the iron ore price to average US$50 a tonne in 2018 as the bears continue to control the market given the sharp build up in iron ore inventory at ports rising to over 140 million tonnes.
What's more, the broker believes iron ore will need to crash under US$50 per tonne before high cost Chinese producers cut production.
If this forecast is accurate, it will not only put pressure on our miners but also the Australian economy as federal treasurer Scott Morrison is banking on a US$55/tonne iron ore price to help lift the budget back into surplus by 2020-21. A US$1 change in the iron ore price is estimated to impact the budget by around $70 million, although a sharp drop in the Australian dollar will help dampen the impact.
Going back to the stock market, the worst affected ASX-listed iron ore stock is Fortescue as its ore is of lower quality than its larger peers. The discount for low quality ore (greater impurities) is likely to increase in a bear market as steel producers tend to favour high grade ore to maximise production.
For this reason, I think investors should avoid the stock until at least iron ore enters into a new bull market. The question is whether you should lump Rio Tinto and BHP into the same category.
As I mentioned last week, BHP and Rio Tinto represents value even in a weak commodity price environment thanks to the strength of their balance sheet. If you are trying to bargain hunt in anticipation for an eventual recovery in the iron ore price, these stocks will represent better risk-adjusted returns.
Those that can't stomach the commodity price roller coaster ride might want to look at the relatively high-yielding quality stock that The Motley Fool has discovered below!
