Adding Iron for a Healthy Portfolio

by Tony D'Altorio

Adding Iron for a Healthy Portfolio

by Tony D'Altorio, Investment U Research Team

August 11, 2009

Hiking along back-trails has a calming effect, is good for your cardiovascular system, and is good for your health in general. It's serene, with few people around.

Hiking along investment back-trails where few Wall Street sales people are around can also have a good effect on you. It can be profitable and very good for your portfolio’s health.

One such isolated back-trail can be found in the world of commodities, which Wall Street usually gives the cold shoulder. This particular commodity does not even have futures traded on it, so Wall Street completely ignores it.

The commodity is iron ore. (Let’s?) take a look at the positive fundamentals for iron ore and the ways that investors can profit from it.

Iron Ore and China

Iron ore is the main raw material used to produce steel and may be more integral to the global economy than any commodity besides oil. After all, nearly 95% of all the metal consumed globally is steel, and iron ore is the key component in steel-making.

Iron ore is therefore particularly critical for developing countries, as the urbanization and industrialization of these societies are built on top of mammoth quantities of steel.

The price of iron ore is also critical to global inflation levels and therefore to the policies of the central banks. Iron ore prices are important because they filter down to into steel costs and, ultimately, into the price of many goods from cars to appliances.

As is true for many commodities, when it comes to the demand for iron ore the 800-pound gorilla in the room is China. Demand for iron ore from China remains strong as its steel-makers in June produced 49.42 million tons of steel – a record monthly high.

In July, China's main ports received 56.5 million metric tons of iron ore, up 35% from last year. For the first half of 2009, iron ore imports surged 29.3% annually to 297 million metric tons. And the imported iron ore is being used quickly. Estimates suggest stockpiles in China are at normal levels with only about 75 million tons of the imported amount left to be used.

Iron Ore Pricing

The key change that is happening in the iron ore industry is how iron ore is priced.

For more than 40 years, iron ore prices have been settled in secretive and often acrimonious annual negotiations between global steelmakers and global miners.

That tradition is falling apart as major mining companies have decided to sell more of their product on the spot market. Recently, BHP Billiton said the iron ore price for a third of its customers would be determined by prices on the spot market.

This event is likely to be a game-changer for the global miners.

Here is why – Instead of being locked in to selling all of their iron ore for a year at a fixed price, the miners will now be able to take advantage of any price rises during the year on a good chunk of their iron ore production. And if prices drop, the miners will still have the fixed price portion of their sales to protect profits.

One needs only to look at 2008 to see how important the ability to sell some of their iron ore on the spot market may be to the mining companies. At one point last year, when demand for steel and iron ore was very strong, the price difference between the fixed benchmark price and the spot price was more than $100 a ton. In effect, the miners were providing large discounts to their customers.

The likely outcome of all this is that in a few years benchmark contracts will become shorter in duration (quarterly), with prices pegged to spot prices. This will lead to higher returns for the global mining companies.

2009 points out how critical this change in iron ore pricing may be to the mining companies. Right now, the benchmark price for the year 2009-10 stands at about $60 a ton. Spot prices have rebounded from an April low of $58 a ton and have breached the $100 a ton level in China.

Clearly the miners could be earning a lot more for their ore if more of it was sold on the spot market, and this logical shift is underway. Here are three companies that investors should look at in order to profit from the changes in the iron ore market.

Adding Iron to Your Portfolio

The two countries that lead the world in iron ore production are Australia and Brazil, so that is where we will look for investment opportunities. The three companies that dominate iron ore production globally are: Vale, BHP Billiton and Rio Tinto.

  • BHP Billiton (NYSE: BHP) is the world's largest diversified resources company and a major producer of iron ore. In fiscal year 2008, BHP generated revenue of $59.5 billion, a profit of $15.4 billion, and net operating cash flow of $18.2 billion. Their asset portfolio is long life, high quality, low cost, and well diversified by product and geography. The company is also conservatively financed with little debt.

  • Rio Tinto (NYSE: RTP) is a smaller version of BHP Billiton. They are a diversified global resources company and also a major producer of iron ore. The recently announced agreement to merge their iron ore operations in western Australia with those of BHP Billiton should be a boon to both companies.

  • Brazil's Vale (NYSE: VALE) is the world's largest producer of iron ore and the second largest producer of nickel, so they are intimately tied to the global steel and infrastructure industries.

Investors can improve the health of their cardiovascular system and their portfolio by adding a little iron to their lives.

Good investing,

Tony D'Altorio

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