It’s gone from bad to ugly in the Australian iron ore industry. The numbers tell the story.

Iron ore was recently selling for about $50 a ton, 60% less than it was in 2013. Slowing demand from China, which buys 70% of the iron ore shipped, is the major reason. But there’s also been a big increase in production, mainly by two of the world’s three largest iron ore producers: BHP Billiton and Rio Tinto.

It may seem counter-intuitive to ramp up production as demand is slowing. Yet BHP and Rio Tinto are doing this for good reason: to gain market share. As the world’s lowest-cost producers of iron ore, their earnings are suffering, yet they remain profitable. Meanwhile, higher-cost producers are feeling the pain.

Witness Atlas Iron Ore Ltd. (ASX: AGO, OTC: ATLGF, ADR: AGODY), which announced in early April that it would shutter all its mines and halt exports to Asia.

Steelmaker Arrium Ltd. (ASX: ARI, OTC: ARRMF, ADR: OSTLY) has closed one of its two iron ore mines in Australia, while Cliffs Natural Resources Inc. (NYSE: CLF) recently suspended a mine in Canada.

CEOs of smaller producers and service providers are lashing out at BHP and Rio Tinto for continuing to increase production even as prices plumb 10-year lows.

Fortescue Metals Group Ltd. (ASX: FMG, OTC: FSUMF, ADR: FSUGY) CEO Nev Power accused BHP and Rio of “ripping the heart out of communities” and harming the nation, as he called for the Australian government to take a look at what’s happening in the industry.

Meanwhile, Fortescue has itself joined the fight. It reported higher iron ore production for the third quarter of fiscal 2015, even as chairman Andrew Forrest warns that ever-higher output is “incinerating” shareholder value.

See Spot Tumble

The spot price of iron ore has been under intense pressure since late 2013, with periodic, short-term bounces dissipating amid ever-increasing supply.

Iron ore pricing did pick up in mid April on news that China imported about 19% more in March (80.5 million tons) than in February.

At the same time, exports from the Western Australian hub of Port Hedland, the world’s largest terminal for iron ore, showed just a 6% year-over-year increase in March, much less than the 30% expansion recorded over the past year.

However, a softening in demand for iron ore may put a lid on any price gains.

Steel consumption in China fell in 2014, the first time since 1995, after years of overcapacity. Low profitability and an effort by the Chinese government to fight pollution could lead to a shutdown of as much as 40% of the Middle Kingdom’s small and medium-sized steelmaking operations.

Therefore, indications are that the price of iron ore could come down even more, with many analysts predicting a bottom in the $30s and a leveling out in the $40s through 2018.

As a result, Standard & Poor’s is threatening to lower the credit ratings of iron producers, including BHP and Rio Tinto, as well as the state of Western Australia, which includes the bountiful Pilbara region. A final decision about the ratings cuts is expected in early May.

Playing Offense

Our iron ore exposure in the AE Portfolio is limited to the Super Two, BHP Billiton Ltd. (ASX: BHP, NYSE: BHP) and Rio Tinto Ltd. (ASX: RIO, NYSE: RIO).

Earnings growth has slowed for both companies, yet they remain quite profitable due to their low production costs. For the second half of 2014, BHP reported a 50% drop in profits, to USD4.27 billion. Yet, after this announcement, BHP raised its dividend by 5% to USD2.42 annually.

Despite lower earnings for 2014, Rio Tinto announced a 12% dividend increase plus a $2 billion share buyback program.

At the same time, both companies are paring back on capital expenditures and instituting cost cuts and streamlining.

Further declines in the price of iron ore could make it necessary for BHP and Rio to cut spending even more or take on additional debt to preserve the current dividend or even increase it. BHP is currently paying out 76% of its earnings as dividends, and Rio Tinto is paying out 80%.

We are much closer to the breakeven price point for the two giants. They’re still profitable at these levels, but there’s not a lot of room on the downside.

It’s possible, too, that Glencore PLC (London: GLEN, OTC: GLCNF, ADR: GLNCY) will attempt to renew merger discussions with Rio Tinto, as spending cuts and belt-tightening will go only so far in the ever-darkening aftermath of the Commodity Super Cycle.

If you own BHP and Rio, continue to hold. They offer decent leverage to commodity-price upside with relatively low downside risk from here.