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The Iron Ore Market Is Set For Further Pain

The iron ore industry had a great 2013. Record levels of output and the rising price of the commodity sent industry profits surging and shareholders were richly rewarded.

However, 2014 is shaping up to be a very different year. For Rio Tinto (LSE: RIO) (NYSE: RIO.US) and BHP Billiton (LSE: BLT) (NYSE: BHP.US) this is bad news. 

Supply but no demandRio Tinto

Both Rio and BHP have been banking on the fact that the demand for iron ore, which was at an all-time high last year, will continue to expand in line with production. 

Unfortunately, this has not happened. The supply of iron ore now hitting the market is far exceeding supply. Indeed, it is estimated that iron ore supply will jump 11% this year to 1.3bn tonnes. In other words, around 108m tonnes of additional supply will hit the iron ore market this year and a similar amount of additional supply is set to hit the market next year, too.

Further, between now and 2017, shipments from producers in Australia and Brazil are expected to grow by 40%. With all this supply being dumped on the market, the iron ore market is now oversupplied for the first time in ten years.

Glencore Xstrata’s (LSE: GLEN) CEO Ivan Glasenberg has hit out at the mining industry for causing this supply glut, stating that the market is being swamped with new supply, while consumption is lagging:

[Iron ore] prices are coming off because we are see massive expansions coming from our major competitors…They continue to expand these brownfields and put more supply into the market.

Glencore has been quick to tout itself as the only miner with real diversity and little exposure to the iron ore market. The company’s only real exposure to iron ore is through its trading arm, although management has just approved a relatively small $1bn iron-ore project in Mauritania. In comparison, Rio Tinto derives 90% of its earnings from iron ore.

Two possible outcomes

With the supply of iron ore rising faster than demand, City analysts believe that there are only two outcomes for the industry. The pessimists believe that as supply increases, and the price of iron ore collapses, higher cost miners will fold. 

On the other hand, the optimists believe that the global economy will absorb the extra supply of iron ore. Their argument is that, as urbanization continues to take hold around the world, iron ore, a key component in the manufacture of steel, will be required in ever greater quantities. 

That said, with so many empty tower blocks and cities scattered around China, it could be said that urbanization has got ahead of itself. 

How low can it go?

So, with the price of iron ore almost certainly heading lower, the question investors should be asking is: how low can it go?

The most pessimistic forecasts suggest that the price of iron ore could drop as low as $80 per tonne, a full 41% below the highs seen last year. However, most forecasts estimate that the price will drop to around $90 per tonne.

Still, a low of $90 per tonne is not good and is around 30% below the highs seen last year. The profits of Rio and BHP could suffer similar declines.

What should you do?

With the price of iron ore slumping, Rio and BHP are likely to suffer, which will mean further pain for shareholders. Nevertheless, in the long-term, the market should return to normality but while you wait, it would be nice to receive some income.

With this in mind, our top analysts here at the Motley Fool have put together this free report, outlining our five favourite dividend stocks.

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Rupert does not own any share mentioned within this article.