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There is one simple rule in the world of business. If someone has some kind of business selling something fungible that anyone can sell, and that business somehow manages to attain very high margins, a lot of different people will step into the same business, trying to sell the same thing, to the point where margins collapse for every seller.

Iron ore is one such business. There isn't a reason not to produce more iron ore at the moment, it just takes more investment. Sure, the mines take a while to come online, but there's no incredible physical limit against which industry might be bumping (unlike oil). Yet, presently iron ore is producing what can only be termed as massive margins. Take for instance BHP Billiton (NYSE:BHP). Around 50% of BHP's EBIT is coming from iron ore, but more importantly, this iron ore is being sold at an unbelievable 65% EBIT margin, above any other product BHP sells, including crude. The same goes for Rio Tinto (NYSE:RIO), while 45% of its 2011 revenues came from iron ore, a massive 70% of its EBITDA was also derived from iron ore. Obviously Vale S.A. (NYSE:VALE) is not much different, with 72.5% of its revenues coming from iron ore.

These margins produce outstanding ROEs, BHP's stands at 38.2%, RIO's at 30.9% and VALE's at 28.2%. Obviously, in a world with 0-5% interest rates, and seeing a sector with no real barriers to entry providing such returns, the flood of investment is predictable. This investment brings with it more production capacity, and is being done both by the established suppliers, as well as smaller ones, as the "Get On Board The Iron Ore Train" article by Colin Lea shows. In normal times, it would be this massive investment in new production capacity that would, eventually, kill margins and returns for the entire industry.

But these aren't actually normal times. There is another factor that will collide with this expanded production capacity. And that is demand. As I have been chronicling for a while now, one of the sectors that, alone, accounts for a great deal of steel (and hence iron ore) demand, is the construction sector in China, and within this sector, residential (as well as commercial) construction. Now, this sector underwent a clear bubble that is already deflating - prices have already been falling for months, buying activity is already falling as well, and soon enough, construction activity will fall as well. This is a certainty. And what will this mean? It will mean reduced steel and iron ore demand. And this reduced demand will hit precisely when every iron ore producer is investing madly in expanded production capacity. It's not hard to predict that this will bring with it violently lower prices and margins.

Prediction

What will the thesis above mean for the iron ore producers? Can we quantify it? In a limited way, we can. We can predict that the ROEs will fall into a range more compatible with an industry producing fungible products and having few barriers to entry. That would be around 10% or so. We can also try to estimate what kind of stock quotes this would produce for RIO, VALE and BHP at several multiples to earnings. What we get is this:

These estimated stock quotes imply the following drops from where the stocks trade today:

And this isn't even a worst-case scenario. This is a scenario where the companies remain profitable. What's usual in a situation with overcapacity is for some of the companies to actually go into losses, until some of the competitors go out of business and capacity is shuttered.

VALE seems to have the least downside because its present multiples already imply that the market is expecting the iron ore market to be impacted. The multiples I used for the estimates are actually much higher than it trades for today, whereas the market seems to still see some diversification benefits in RIO and BHP.

Conclusion

The present margins and ROEs being obtained in the iron ore market are unsustainable, because they are too attractive and since there are few barriers to entry it is unavoidable that new entrants and production capacity expansions will flood the market until such margins and ROEs become less attractive. Worse still, the iron ore capacity expansion will collide with stagnant or reduced demand, due to China's residential market slowing down (something that is already happening). This will result in stagnant or reduced volumes and deeply undercut prices, which will lead to much lower margins and profits in the industry.

Source: Iron Ore Margins Can't Last