Iron is vital to the global economy because it's an essential ingredient in making steel. Overall, about 98% of the iron mined each year goes into the production of steel. That metal is a crucial building block of global infrastructure like bridges, buildings, and pipelines. It's also in a variety of other items like cars, ships, appliances, tools, and wind turbines. In 2018, about 51% of the steel produced went into buildings and bridges, with another 12% used to make automobiles.

Steel's vital role in building the backbone of the global economy is why iron is the mining industry's largest metals market by volume as industries demand more of it than copper or aluminum. Overall, iron typically ranks as the third biggest commodities market by dollar value behind oil and gold.

Given the importance of iron to the global economy, it's an essential metal for investors to understand. This guide will walk them through the key things they need to know about this sector.

Image source: Getty Images.

What is the iron industry?

The iron industry mines iron ores and processes them so that the steel industry can use them to manufacture various forms of steel. Iron producers extract the ore from rocks that typically contain other elements like nickel. The mining process starts with digging up ore-rich rocks, which the industry crushes into smaller pieces. The iron-rich ore then goes through several refinement steps, which use water to separate it from other materials. This process helps transform it into coarse-grained clumps that the steel industry can use. The steel sector takes the processed iron and mixes it with pure carbon that it extracts from coal. It melts this mixture in a blast furnace to produce a molten iron known as pig iron. The steel industry uses pig iron to manufacture steel.

Given the vital role iron plays in building the global economy, many of the world's largest mining companies produce this raw material. In addition to that, some major integrated steel producers also mine and process iron ore. Here are the five biggest players in the iron market, as ranked by their market capitalization (a company's total available shares multiplied by its stock price):

Data source: Company investor relations websites. Market capitalization as of October 20, 2019.

What are some key iron industry metrics?

Investors who are interested in the iron industry need to understand the language that mining companies use to communicate with investors. That starts with getting to know some of the metrics that the sector uses to measure its performance. Three of the most important ones for investors to know are:

By-product credits: These are cash payments that mining companies receive for producing raw metals in association with their main target, which is iron ore in this case. Instead of spending the money needed to process these raw metals into finished products, miners will sell them to other producers for further processing. They then use the payments received to reduce the cost of mining iron ore. Some iron ore mines, for example, contain small quantities of gold and other precious metals that the iron mining company will sell to others focused on those metals rather than producing them as part of their operations.

C1: Iron ore mining companies use several metrics to help investors understand how much it costs them to produce one ton of marketable ore. One of the most common is their unit costs or net direct cash costs, which many refer to as C1. This metric measures the actual cash costs an iron ore mining company incurs at each processing stage -- from mining to delivering metal to the market -- minus any by-product credits. As such, it measures what it actually costs to produce marketable iron ore before factoring in indirect corporate costs like interest expenses and accounting costs such as depreciation and amortization.

EBITDA: EBITDA is an acronym that stands for earnings before interest, taxes, depreciation, and amortization. It's a non-GAAP metric, which iron ore miners use to provide their investors with the underlying earnings-generating capability of their ore business. They use this metric because they typically record large depreciation expenses as they deplete a mine's reserves, which reduces their reported net income. Because of that, iron ore miners often seem like they're not making much money, which might not be the case.

What are some headwinds facing iron stocks?

Economic growth is the lifeblood of the iron industry. As the global economy expands, it drives demand for more steel to construct new buildings, bridges, vehicles, and appliances. Because of that, one of the biggest potential headwinds facing the sector is an economic slowdown. If the global economy goes into recession, it will cause the demand for steel to decline, which will negatively impact the price of iron ore. That would cut into the profitability of companies that mine that metal, likely causing their stock prices to plunge.

While countries all around the world use iron and steel, China is by far the biggest consumer. In 2017, that one economy used 45% of all the steel produced. Because of that, if China's economy slows down, it would have an outsized impact on demand for steel and the iron ore market.

Several other factors can also impact iron demand, including rising interest rates and a slowdown in a key steel-consuming industry like automotive. Rising interest rates, for example, make it more expensive for companies to borrow money, which can cause them to invest in fewer building projects, thus impacting steel demand. Meanwhile, the U.S. automotive industry accounts for 27% of the country's demand for steel. As such, when fewer American consumers are buying cars, it can negatively impact the iron sector.

Tariffs on imported steel can also impact iron demand and prices. In 2018, the U.S. imposed a 25% tariff on imported steel to help level the playing field for American steel companies versus their global competitors. Those higher steel prices, however, negatively impacted demand, which weighed on iron ore prices.

Another issue that mining companies can run into even during periods of strong economic growth is overcapacity. The steel industry can overestimate demand and produce more than the economy needs, which will then reduce that sector's demand for iron ore. Likewise, iron ore producers have routinely built more mining capacity than needed to supply the steel sector's demand. Both of those issues can weigh on iron ore prices and mining company profitability, which can cause iron ore stocks to lose value.

An emerging headwind for the iron industry is climate change. The global iron and steel industries are responsible for 7% to 9% of direct carbon emissions, according to a report by the Financial Times. Meanwhile, those two sectors contribute about 24% of the industrial sector's total emissions. Because of that, these industries need to reduce their carbon footprint so that they're part of the solution, not the problem.

One company, for example, that's working to become part of the solution is industry-leader Vale. The Brazilian iron giant ships its iron ore to global markets on Valemax ships instead of the traditional Capesize vessels. These larger ships carry 400,000 metric tonnes of iron ore apiece, which is 2.3 times more than Capesize vessels. Because of that, they emit 35% less carbon dioxide per ton.

Image source: Getty Images.

What are some tailwinds that could bolster iron stocks?

Steel is vital for building the infrastructure needed to support economic growth. Both governments and the private sector use it to construct transportation networks such as bridges, tunnels, and railways as well as transport-related facilities like gas stations, train terminals, ports, and airports. Utilities, likewise, use lots of steel to build infrastructure such as pipelines for distributing water and natural gas as well as for electricity transmission systems.

The global economy needs to invest a staggering amount of money into building new infrastructure in the coming decades to both replace aging assets as well as to construct more capacity. The U.S. economy alone needs to invest an estimated $4.6 trillion on infrastructure by 2025, according to The American Society of Civil Engineers. Meanwhile, the global investment requirement is a jaw-dropping $69 trillion by 2035, according to a report by McKinsey & Company. Those estimates suggest that iron demand should remain healthy in the coming decades.

Steel is also vital to the energy industry. Oil and gas companies, for example, use lots of it to drill new wells and for pipelines to move hydrocarbons from production regions to end-users. While climate change concerns will likely cause demand for oil and gas to eventually plateau, the International Energy Agency expects the consumption of these fossil fuels to continue rising through at least 2040, which will fuel that sector's need for more steel.

The renewable energy industry also uses lots of steel. The solar industry, for example, uses it as a base to hold solar panels, while hydroelectric systems use it to reinforce concrete dams. Meanwhile, it's the main material used to build wind turbines as well as for wave and tidal energy systems. Because of that, as the renewable energy sector expands, it will consume even more steel, driving incremental demand for iron.

What are some opportunities for iron stocks?

While China is the world's largest iron and steel market, other Asian economies consumed a combined 22% of the world's steel in 2017. That percentage should rise as Asian economies like India, South Korea, Vietnam, Indonesia, Thailand, and the Philippines continue growing. This region's rising steel consumption could provide new growth opportunities for iron companies that focus on supplying mills in those countries.

One of the biggest non-regional growth opportunities for iron producers is renewable energy. Iron and steel, for example, are in nearly every part of a wind turbine, including the tower, rotor, and foundation. Overall, the average wind turbine is about 80% steel and uses roughly 140 tonnes of that metal. Because of that, the continued growth in wind development is a major opportunity for the iron sector.

Steel is also an important component for emerging renewable energy technologies such as wave and tidal energy, which use the ocean's currents to produce clean energy. A steel pile, for example, is the primary part of a tidal turbine. Meanwhile, the metal is also used to make wave energy devices. Because of that, as the renewable energy sector begins to commercialize these emerging technologies, it'll provide the iron ore industry with a new growth opportunity.

Not only will new technologies drive additional demand for steel, but innovation can also make the industry more profitable by helping reduce costs. Leading iron ore producers like BHP Group and Rio Tinto, for example, are utilizing autonomous trucking technology to increase safety and productivity, which is also helping reduce costs. As the industry accelerates its adoption of technology, it can reduce downtime, which should increase the sector's production and profitability.

Image source: Getty Images.

What are the risks facing iron stocks?

Because iron ore is a commodity, its price tends to be highly sensitive to changes in supply and demand. If the global economy slows down or mining companies produce more iron than the steel sector needs, the price of iron ore can plummet. The decline in price will have a direct impact on the profitability of iron ore producers and their stock prices.

Iron miners use lots of water to separate the ore from rocks. The left-over water often contains small mineral particles and toxic materials such as arsenic and mercury, known as tailings. The industry stores these tailings in large ponds that they build to prevent them from running off into the environment. These tailing ponds, however, pose a significant risk. Should a dam supporting these ponds fail, it would release that toxic mixture into the environment.

The iron ore industry has experienced two notable dam failures in recent years. In 2015, a dam supporting a tailings pond for the Samarco iron ore mine in Brazil -- which is jointly owned by Vale and BHP Group -- collapsed. The disaster killed 19 people and buried a village. That tragedy cost the mining partners dearly as they've spent $5 billion to settle a civil claim with local authorities as well as to establish a clean-up fund.

Meanwhile, another of Vale's iron ore tailing ponds in Brazil failed in early 2019. That catastrophic dam collapse killed nearly 250 people. It also caused shares of the company to tumble 24% on the news, which wiped away $19 billion of its market value. The company had spent or set aside $6 billion to remediate the damages that mine caused as of mid-2019.

What are some ways to invest in iron stocks?

On the one hand, the iron ore sector can be a challenging one for investors due to the industry's headwinds and risks. However, it also holds lots of promise due to its importance to the global economy and renewable energy. That upside makes it one that investors will at least want to consider including in their portfolio.

They have three main ways to do that. First, they can invest in a company that mines iron ore. Some like Vale and Rio Tinto, make a majority of their money from mining that commodity. Others like BHP Group and AngloAmerican, meanwhile, are more diversified and therefore get less than half of their income from mining that commodity. Because of that, investors need to dig into a mining company's portfolio to see whether iron is the main driver before buying shares.

Another option is to buy an integrated steel company like ArcelorMittal. That path provides investors with upside to not only the iron market but also the steel industry.

The final option is to consider investing in an exchange-traded fund (ETF) or a mutual fund that focuses on holding the stocks of companies that produce iron ore. While there aren't any noteworthy ETFs focused exclusively on iron, the iShares MSCI Global Metals & Mining Producers ETF, for example, holds shares of roughly 200 companies that operate in the metals and mining sector. Among its top-ten holding as of October of 2019 where iron ore miners BHP Group, Rio Tinto, Vale, and AngloAmerican and steel producers POSCO and Nucor. As such, investors in this ETF gain broad diversification across the entire mining industry, including a large focus on iron and steel.

Why should investors consider iron stocks?

Iron ranks right up there with crude oil as being among the most crucial commodities to the global economy. That importance could grow in the coming years, given that steel is an essential component for renewable energy, especially wind power. That upside to economic growth, as well as the renewables sector, is why investors should dig into this industry to see whether adding an iron-focused stock might make sense in building their portfolio.

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Matthew DiLallo owns shares of BHP Group Ltd. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.