Minnesota iron ore production rose slightly in 2012, a third consecutive annual increase and another sign of the industry's recovery from a recession-induced downturn.

Taconite output climbed to 39.2 million tons, up 0.8 percent from 2011, according to state data released Thursday. The state Revenue Department's 2012 figure is based on 11 months of production and the estimated output for December.

Yet the iron mining industry faces challenges in 2013, even though world prices for iron ore have rallied in recent weeks. The department forecast a nearly 5 percent drop in production next year.

"We have to get past all of the talk of the fiscal cliff and see a recovery continuing in the economy," said Craig Pagel, president of the Minnesota Iron Mining Association, a trade group based in Duluth. "That will only strengthen the iron ore industry in Minnesota."

The Minnesota Revenue Department, which tracks Minnesota iron ore output to collect production taxes, forecast a drop in output to 37.3 million tons next year.

That's still twice the output of 2009, when Minnesota ore production dropped to 17 million tons, the lowest since 1963, when the state had just three taconite operations. There are nine producers today, including two that began production in the past three years.

Bob Wagstrom, an Eveleth-based engineering specialist who works on the department's taconite figures, said the 2013 projection is based largely on Cliffs Natural Resources' recently announced cut in production at its Babbitt mine and Silver Bay taconite processing plant. The cutback, which takes effect next week, will result in the layoff of 125 workers.

Cliffs' operations in Minnesota and Michigan mainly serve U.S. customers, said Sandra Karnowski, a company spokeswoman. "They have opted for fewer pellets than they have in past years," she said Thursday.

That cutback may be partly offset by expanding production at two recent arrivals to the Iron Range -- Magnetation, which extracts ore from old tailings, and Mesabi Nugget, which produces 97 percent metallic iron from ore. Wagstrom said the two companies are expected to boost production next year.

The recent rally in iron ore prices comes after hitting a three-year low in September. The rally is driven partly by a resurgence of demand in China, where a benchmark price is up 56 percent since the slump.

"We're seeing the recovery come through in China," Justin Smirk of Westpac Banking Corp. told Bloomberg News, which ranked him as the most accurate industrial-metals forecaster last year. "They've made a switch to their policy adjustments from being contractionary to be more stimulatory."

Yet China's resurgence may have little effect on the Iron Range. Pagel said almost all Minnesota producers are vertically integrated, supplying ore to their own operations. Some ore is shipped abroad, but it rarely goes to China.

Instead, Pagel said, the iron mining industry has been buoyed by the revived U.S. auto industry and increased steel pipe production for the U.S. oil and gas industry. He said the revival of the housing construction industry could help another steel-related market -- appliances.

David Shaffer • 612-673-7090 Twitter: @ShafferStrib