As any seasoned investor knows, Wall Street has a tendency to overreact, and that's happening right now with one of the most important metals on Earth...
At the moment, commodities analysts flat-out hate iron ore.
Forecasters at prominent brokerage houses like Goldman Sachs and Morgan Stanley have slashed their short and long-term price forecasts. And top Australianeconomists are projecting prices to slide from an average of $119 per ton this year to just $90 per ton by 2015.
Nobody knows the iron ore market better than Australia -- which feeds a million tons of the raw materials to China's hungry steel mills every day. So we need to forget about investing in iron ore for the foreseeable future, right?
It's not that the analysts are wrong. I agree that iron ore is probably headed downward. The headwinds have already started to blow. The metal had been in rally mode for much of the year, doubling to $160 per ton from a low of $87 last September. But in recent weeks it has retreated back toward $130.
The problem isn't weakening demand, but rather an influx of new supplies. When prices were still high, three of the world's biggest producers responded by investing in new expansion projects. And those expansions are about to take hold.
Over the next three years, output from BHP Billiton (NYSE: BHP), Rio Tinto (NYSE: RIO) and Fortescue Metals (OTC: FSUGY) is expected to rise by a combined 235 million tons. For context, that's about half of Australia's current annual production. About 488 million tons of iron ore left Australian ports last year -- mostly bound for China.
This year, the total is expected to top 550 million tons.
Even for China, that influx of new supply will be difficult to absorb. That's why many analysts fear a supply glut on the horizon. I believe that incremental supply will indeed outpace incremental demand -- but not to the degree that everyone is expecting.
Production at new mines is notoriously difficult to predict and may not come online as fast as expected. Furthermore, China's iron ore appetite will continue to grow as the country invests heavily in construction and infrastructure. Beijing plans to invest $105 billion in railway projects alone this year. And by some reports, the county is erecting a new 500-plus foot skyscraper every five days on average.
You can imagine the steel needed to construct just one of these massive buildings. According to Bloomberg, China's overall steel consumption could rise 5% this year, which would lift iron ore imports to 773 million tons -- about 30 million more than 2012. Sure, consumption will ebb and flow with the economy. But the country continues to industrialize and grow -- it's just a matter of how fast.
So even if prices do head south temporarily, I don't see them falling much below $110 on a sustained basis. That's the average cost of production in China. When prices slide below that level, domestic mines can't turn a profit. Many would bleed money and be forced to idle or close.
In the cyclical commodities world, the best time to invest is usually at the point of maximum pessimism, when assets are sharply underappreciated and undervalued. We're not quite there yet, but major producers like Rio Tinto and Fortescue Metals are starting to look attractive.