Red-hot demand for iron ore (from which iron is extracted), driven by such countries as China, has fueled an insatiable global appetite for the commodity over the past decade. Now, however, with the ongoing slowdown in the Chinese economy (for more, read: What Happens to the Economy if China Deleverages), demand for iron ore is expected to diminish, with prices already tumbling as the sector faces too much supply for too few buyers.

Why is iron ore so essential to economies worldwide? Iron production, particularly steel, is a fundamental resource for a developing economy, especially a country like China that is experiencing rapid growth in a relatively short period. Steel alloys (formed by adding other metals to iron) are critical to construction and engineering projects. Iron and steel products are the building blocks of a country's transportation industries and its oil and gas extraction and distribution facilities. They're also found in a wide array of manufacturing, from appliances to shipping containers.

Impact of Chinese Slowdown

China has become one of the world’s largest iron consumers. Its economic boom, which has been driven by manufacturing and the country's gangbuster attempts to build infrastructure and urban housing, has been fueled by massive amounts of raw materials such as iron ore. According to BHP Billiton (BHP), a top Australian iron ore producer, Chinese demand has helped iron ore production to rise by more than 100% in 14 years, going from 950 million tons produced per annum in 2000 to 2,200 million tons in 2014.

However, the Chinese economy finally appears to be cooling off after some 20 years of fervid growth (see also China's Economic Indicators, Impact on Markets), and already some effects are being felt by iron ore producers. Chinese steel production was down in early 2015, the first such decline posted since 1994, and Chinese iron ore imports slumped for the first half of the year. Demand in China is becoming so tepid that Chinese mills, which typically serve an array of internal customers, are now exporting more of their production.

Rio Tinto (RIO), another Australian iron ore exporter, expects Chinese demand for steel to be muted for years, as China has to contend with a major oversupply of housing. Until this massive unsold inventory of houses, condominiums and commercial properties diminishes, the Chinese home-building sector has little incentive (and may have little capital) to launch many new projects. What once had seemed like an endless thirst for iron and steel finally appears to be drying up.

Growing Supply of Iron Ore

As Chinese demand slows, global iron ore supply keeps steadily growing. Major suppliers of iron ore include Australia, Brazil, India, South Africa and, of course, China itself.

According to Goldman Sachs researchers, iron ore shipped from Australia will hit 785 million tons in 2016, up from the 764 million tons expected in 2015. By the same token, Brazilian iron ore exports should reach 411 million tons next year, compared to the 367 million tons predicted this year. At the same time, analysts expect a 1.3% drop in global demand in 2015 and predict a tepid 1.1% growth in 2016.

Back when it seemed as though there would be no end to China's need for iron ore, producers around the world (including China) kicked up production by expanding mining and refinery facilities. There already have been signs for years that this boom was unsustainable, with production growing too quickly even for a hot market. BHP Billiton estimated that the global supply of iron ore overtook global demand somewhere around 2011. Iron ore prices have been restrained for years already. Now, given the slowdown of one of the world's hungriest economies, there's nothing on the horizon to suggest that prices will rise any time soon.

Impact on Price?

From 1980 to 2005, as global demand steadily grew due to rising industrialization in countries like China, the price of Australian iron ore exports was on average $30 (USD) per dry metric ton, according to BHP Billiton. And once Chinese demand went into its supernova stage in the mid-2000s, the average price shot rose to $96 (USD) per dry metric ton from 2005 through early 2015. At its peak, Australian iron ore hit a high of $180 (USD) per dry metric ton. (By comparison, the average price over the past 35 years has been $49 (USD) per dry metric ton.) (For more, see: How the Iron Ore Market Works.)

Those heady days are well over now. Goldman Sachs analysts expect iron ore prices could fall by up to 30% through early 2017. Analysts predict iron ore prices to average $49 a ton in third-quarter 2015, $48 a ton in the fourth quarter and to sink to $44 a ton by second-quarter 2016 (which is also their prediction for 2016's overall average price).

RBC analysts have somewhat of a rosier outlook. They expect iron ore prices to average $55 per ton for 2015 and even rise slightly to $56 per ton for 2016. By 2019, RBC expects a market recovery to get underway, with prices then averaging $65 per ton.

Long-term Outlook

So while the next few years don’t look promising for iron ore producers, the sector's long-term outlook remains fundamentally positive. After all, developing countries will continue to have millions of their citizens move from rural environments into an urbanized and industrialized mode. As India, African and South American countries continue to expand their economies, they will need iron ore and steel products. Even China, despite its current problems, should keep being one of the world's largest consumers of iron ore, as its population keeps up the process of urbanization.

The Bottom Line

As the world economy develops, it fuels strong demand for iron ore. The problem is when China, the biggest driver of this growth this century, finally hits a bump in the road and its economy slows down. A substantial decline in demand for the metal puts deflationary pressures on iron ore prices for the short- to medium-term. However, once supply and demand get back into balance, the price of iron ore should likely continue its long upward march.