We're seeing a high stakes game being played out in the iron ore market – major producers BHP Billiton Limited (ASX: BHP), Rio Tinto Limited (ASX: RIO) and Vale. Inc are ramping up production significantly – right in the face of increasing stockpiles and declining prices. As a result heavy pressure is being placed on higher cost operators such as Fortescue Metals Group Limited (ASX: FMG) and some Chinese domestic producers.
However commercial history is littered with examples of such tactics backfiring on the instigators and this chapter may be no different. For one thing China (the major customer) is a controlled economy and is unlikely to allow too much of its own iron ore production to shut down. In the longer term China and other customers will be seeking to diversify supply – whilst enjoying the benefits of shorter-term gifts from the over-producers.
So how are BHP and Rio placed in the above context? Both are increasingly dependent (especially Rio) on the health of iron ore demand. Although both are increasing production, an overvalued A$ and falling realised prices tend to cancel the benefits. Return on equity is in decline, the necessity to hold more capital is increasing and these factors alone suggest their share prices are vulnerable.
On the bull side, BHP's increased production is estimated to be at an incremental cost of US$50 per tonne which is well below current iron ore prices. Rio has similar parameters. So there is no problem about both companies staying in business and generating positive returns. In addition both companies (especially BHP) have substantial franking credits available.
Although some investors were disappointed with BHP not going ahead with a share buyback, it is a sign of good management determined to retain a healthy capital position when faced with uncertain outlooks. In addition existing BHP shareholders may not want to miss out on the spinoff of the more dynamic NewCo.
Although BHP ($36.59) and RIO ($62.27) are excellent companies this doesn't make them good investments at current prices. With only moderate earnings growth (at best) expected over the medium term and an increasingly murky outlook, the margin of safety is insufficient in my view to justify any new investment.
