Iron Ore Prices May Not Bounce Back, This Iron Ore Stock Will
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I've read more about the marginal cost of iron ore than I care to admit. I have a life, I swear! What I find interesting is that the sell-side analysts are lowering their estimates of marginal cost as spot prices continue to fall. Before the latest leg down to $115 per metric tonne, analysts reported that global marginal cost was $125-$135 per tonne. Now from what I read it's $110-$120. Analysts like to point out that the market price is near marginal cost to be able to reiterate that now's the time to buy.
The marginal cost of a commodity is often defined as the highest 10% of the cost curve. This is an important number to know. Analysts, customers and producers use marginal cost assumptions to make key decisions about which new projects to go after and how aggressive to grow organically.
The global marginal cost for iron ore appears to be the price at which the highest cost Chinese producers start to throw in the towel. Whether that price is $110-$120 or $120-$130 per tonne, (I consider $120 a base case, plus or minus $10 per tonne), I will let Foolish investors in on a dirty little secret. The top three iron ore producers, Vale (NYSE: VALE), Rio Tinto (NYSE: RIO) and BHP (NYSE: BHP), have cash costs in the $40's and $50's per tonne. These giants control more than half of the global market. Guess, what? They can live with $120 iron ore, or $110 or $90. Of course as profit maximizing firms they may act (not in concert of course!) to keep iron ore prices above say $100 per tonne.
This suggests that the BIG 4 producers are more important than global marginal cost in determining market prices. Still, marginal cost is extremely important because emerging iron ore producers need to plan for the next five to 25 years. If true marginal cost is perceived to be $100 and falling, then many green field projects are too risky to pursue, i.e. they won't get funded. If conventional wisdom says that marginal cost is $130 and rising, then more supply is surely coming.
Importantly, investors will not necessarily get big exposure to iron ore by owning BHP or Rio Tinto because those companies have other business segments as big or bigger than iron ore. For example, BHP is much bigger in oil & gas than iron ore and has a formidable coking coal franchise. Rio Tinto is currently getting the lion's share of earnings from iron ore, but it has a massive copper/gold project in Mongolia coming on-line next year and it is also growing its coal portfolio.
In order to get the most iron ore for one's buck, investors should look at mid-sized pure-play iron ore producers. These players will not only more closely track iron ore, but they make attractive takeout targets as well. A name that many investors are familiar with is Cliffs Natural Resources, (NYSE: CLF). Cliffs has some high cost coking coal assets, but the vast majority of its operations are iron ore in Canada, the U.S. and Asia. The company is currently working through growing pains from last year's over-priced acquisition of Consolidated Thompson. This deal will work out in the long run, but 2012 is no longer the time period to measure its performance.
Next year will be the key. In the meantime, CLF is yielding about 5.6% and has reiterated its commitment to maintain the dividend. Cliff would be an attractive addition to any of the big 3's portfolios. For example, Vale is heavily concentrated in Brazil. Cliff's North American iron ore assets would diversify Vale's Brazilian base. To be clear, an acquisition of CLF is not going to happen soon, but as they get their house in order, next year could be a different story.
MockingJay2011 owns shares in CLF. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.