Steel wheels are slowing for iron ore producers

A slowdown in global industrial steel production could spell bad news for the share prices of BHP Billiton and Rio Tinto.

Steady fixed-asset investment in China should see China’s steel output exceed 800 million metric tonnes next year according to Li Xinchuang, vice secretary-general at the China Iron and Steel Association.

Normally it takes around 1.5 tonnes of iron ore to make one tonne of pig iron, which can then become steel. On this basis, we could estimate China would need a minimum 1,200 tonnes of iron ore to meet its steel output guidance.

BHP has estimated they will produce a total of 192 million tonnes of iron ore in the 2014 financial year, with the total production of all of its projects to come in at 265 million tonnes.

BHP and Rio are by no means the only iron ore producers, but they do account for the lion's share coming from Australia. Given China has made up just under around half of global steel output over the past four years, there has always been plenty of capacity elsewhere to pick up any slack in the iron ore market.

However, things could be changing. It looks like global industrial production is peaking, following an impressive run since the last quarter of 2011. If this is the case, it is expected global steel output will fall, along with the broad need for iron ore.   

The question remains how the iron ore price will react. Historically, we have seen iron ore prices overshoot to the downside on numerous occasions over the past few years or so amid fear China’s industrial production would simply evaporate.

There has been much conjecture about when iron ore would experience price weakness, and it is conceivable it may not arrive anytime soon. Varying estimates have the iron ore market reaching excess supply in the second half of next year when projects initiated over the past five years will be delivered.

In the meantime, there is plenty of scope for the iron ore price to find lower ground if demand is not sufficient to meet current supply levels.

Historically, prices of iron ore majors BHP Billiton and Rio Tinto have loosely moved in tandem with the iron ore price. However, as production is ramped up and cost per tonne falls, increasing operating margins and overall profitability per tonne produced, there is potential for the relationship to modify. It is feasible to assume lower iron ore prices won’t necessarily equate to lower share prices if volume is robust enough.      

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