Summary

• While iron ore prices keep dropping, mining companies are increasing output.

• Some iron ore suppliers have a competitive advantage that they can take advantage of.

• The current developments may seem bad short term, but could be a blessing in disguise in the long run.

There should be little doubt that times are changing in the iron ore industry. It used to be that iron ore was in short supply because of excess demand, which resulted in drastic price increases for iron ore that lasted for a number of years. At one point in February 2011, prices for iron ore hit their peak at around $190.

In order to take advantage of high prices and meet increased demand for iron ore, a large number of iron ore suppliers joined the ranks of the more established players such as BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO) and Vale (NYSE:VALE) who dominate the iron ore industry.

For the most part, the large increase in demand for iron ore has been due to China. For instance, steel production in China almost doubled from 2007 to 2014 to reach 822.7 million tonnes ("Mt"). That's almost half of the 1662 Mt produced globally.

However, Chinese steel production in 2014 only increased by 0.9 percent over the previous year, which is much lower than in previous years. Taking into account increased exports of steel, one could argue that internal demand for steel in China has declined.

Prices for iron ore have collapsed

With steel production in the world only up by 1.2 percent in 2014, supplies of the iron ore needed to make steel has surpassed demand. Prices for ore with 62 percent iron content dropped by 47 percent in 2014. The decline in prices has continued in 2015 along with forecasts and are now at their lowest since 2009.

Meanwhile, supplies of iron ore keeps increasing. Global seaborne surplus of iron ore could reach 47 million tons in 2015 as miners continue to ramp up output. For instance, Rio Tinto expects to raise output from 295 million tons in 2014 to 330 million tons in 2015. BHP intends to boost output from 204 million tons in 2014 to 225 million tons in 2015.

At first, this might seem like a bad decision on the part of the mining companies. After all, the logical thing to do for some people is to reduce output of iron ore as prices continue to decline. However, there is a good reason as to why increasing output in the face of falling prices makes perfect sense.

China has an incentive to import iron ore

Even though China is the biggest producer of iron ore, the country still needs to import iron ore from abroad to produce all the steel it needs. In fact, China accounts for 70 percent of the seaborne trade in iron ore, which amounted to about 1.3 billion tons in total.

Imports accounted for 78.5 percent of the iron ore China needed, an increase of 9.7 percent over the previous year. The average price paid for iron ore was about $100, which is about $29 less than what was paid the previous year.

For the year, Chinese imports of iron ore increased to 932.5 million tons from 820.3 millions tons the previous year. That's an increase of 13.8 percent. Such a large increase in iron ore imports stands in sharp contrast to steel production which only increased by 0.9 percent.

The big miners have a competitive advantage

While some of the additional iron ore was used to restock iron ore reserves, the large gap between iron ore imports and steel production is an indication that a substantial amount of iron ore mined domestically within China was replaced with foreign counterparts.

Iron ore in China tends to have a lower iron content, typically between 20 to 40 percent. On the other hand, the ore mined by the big mining companies (Rio, BHP and Vale) in places such as Australia and Brazil usually has iron content of at least 60 percent.

The iron content in low grade ore can be raised to the 60 percent level needed by the steel mills through the process of beneficiation. However, this is an extra step that takes time and raises costs. Therefore, it makes sense financially to replace some of the domestic iron ore with imported ore as long as prices are low enough.

Replacing expensive iron ore with cheaper ones will take time

While substituting lower grade iron ore can increase profitability, replacing them will take time and cannot happen overnight. Many of the steel mills in China have long-term contracts for iron ore in place which have to run their course.

In addition, a number of steels mills have integrated operations with their own iron ore mines. Opening a new mine is costly and simply shutting them down is often not feasible in the short term. Therefore, there are limits as to how far and how quickly imported iron ore can replace domestic iron ore in China.

With that said, Chinese imports of iron ore from places such as Indonesia, Malaysia and Iran is declining even though the country is importing more. At the same time, Australia's share of imports increased from 51 percent in 2013 to 59 percent in 2014.

This is an indication that current market conditions are having a profound effect on suppliers of iron ore. As prices continue to decline or stay suppressed for a long time, these changes will force the iron ore market to consolidate and separate the weak from the strong.

Implications for the big mining companies

In some ways, the iron ore industry resembles the oil industry. When demand exceeded supplies and prices rose, there was a lot of room for additional suppliers. It did not really matter that their supplies was more expensive to produce as long as there was sufficient demand to absorb their output.

With excess supply and prices falling, companies with lower costs are in a better position than those with higher costs. It may take some time, but eventually Rio, BHP and Vale should come out on top once some of the other suppliers have been removed from the iron ore market. Initially, their margins will take a hit as prices fall, but increased market share can help offset that.

The first two especially are in a good position. The average production cost for Rio and BHP in Pilbara is about $25, which other companies will find hard to match in a price war. On the other hand, Vale is at a disadvantage due to the fact that shipping from Australia is cheaper and faster than Brazil.

Short term, the current situation in iron ore may not seem favorable to the mining companies. Their stock prices reflect that. However, it could actually turn out to be a positive development in the long run. Considering that iron ore accounts for most of the profits for all three companies, that is of great importance. Investors may want to take that into account.