Are BHP Billiton and Rio Tinto Right to Play Down the Iron Ore Slump?

BHP Billiton and Rio Tinto might be prematurely playing down the recent slump in iron ore prices.

Mar 13, 2014 at 12:21PM

Shares of BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO), and Vale (NYSE:VALE) came under significant pressure earlier this week as iron prices slumped. Iron prices have since recovered slightly, and so have shares of all three companies. Meanwhile, BHP Billiton and Rio Tinto have played down the slump in iron ore prices, saying that demand for the bulk commodity should remain strong. But are they right?

BHP and Rio still upbeat
Although iron ore prices slumped earlier this week on worries over Chinese demand and credit tightening, BHP and Rio Tinto remain upbeat over the long-term demand. Rio Tinto CEO Sam Walsh said earlier this week that no one should be surprised by China's efforts to close some of its older steel mills. Walsh said that demand for iron ore should remain strong regardless of the closure of some older steel mills. He noted that the Chinese efforts were addressed toward overcapacity in the steel sector and not the sort of customers Rio deals with. Walsh added that Rio's customers are blue chip steel mills.

BHP Billiton also played down the slump, with the company's iron ore president Jimmy Wilson saying that his long-term view is still very robust. Wilson said that the long-term thinking should not be influenced by today's price. Wilson also touched upon the credit issue in China, which as I have discussed previously is one of the reasons behind slump in iron ore prices.

Are the two miners right in playing down the slump? As I noted in a previous article, the likes of Rio Tinto and BHP, which have lower production costs, will benefit at the expense of miners in China who have high production costs. Indeed, if iron ore prices were to slump further to around $90 a ton, some high-cost mines in China could face closure. Smaller miners in Australia, which have high production costs, could also struggle.

Both Rio and BHP Billiton have significantly lower production costs thanks to their size. They can still make a decent profit if iron prices were to slump to $80 a ton. But at that level, both companies will see a significant reduction in their free cash flows. And that is the major worry, as it will affect the two companies' efforts to pay down their debt and reward shareholders. Also, Rio's and BHP's assertion about robust long-term demand from China can be questioned in the wake of comments from Chinese premier Li Keqiang on Thursday.

Plans affected
Both BHP Billiton and Rio Tinto last month reported robust financial results. While BHP posted a 31% increase in profit for the six-month period ended December 31, 2013, Rio registered a net income of $3.7 billion for full-year 2013. Both companies were helped by robust iron ore prices. Recall that Rio even raised its dividend by 15% in the wake of strong results and robust outlook. The company also said that it expects to cut its net debt in 2014, which would allow the Board to consider more returns to shareholders. BHP also said that its net debt is expected to fall to $25 billion by the end of fiscal year 2014. BHP's CEO Andrew Mackenzie also signaled possible share buybacks if the company lowers its debt levels.

In the wake of weaker iron ore prices, those plans will be certainly affected. During the commodity supercycle, miners were seen as high-growth companies, but that has changed ever since the commodities boom ended. Weaker commodity prices and demand have prompted miners to focus on achieving operating efficiencies and generate significant free cash flows to reward shareholders and repay the huge debt they took on during the boom years. But weaker iron ore prices would now negatively impact miners' efforts. Also, prices could remain weak in the long term due to lower demand from China, which remains focused on rebalancing its economy.

On Thursday, the Chinese premier said that China is expected to see a series of bond and financial product defaults as the government continues on the path of financial deregulation. Chinese policymakers are focused on rebalancing the economy, which is highlighted by comments from the Chinese premier.

A Chinese economy tilted more toward consumption would have a negative impact on long-term demand for raw materials. Therefore, iron ore prices could remain weak unless the Chinese demand is replaced or supply is cut. Both look unlikely. In fact, on the supply front, there is expected to be an increase this year.

Even if iron ore prices were to average $90 in the long term, the likes of Rio Tinto and BHP Billiton will make decent profit. BHP Billiton, given its more diversified portfolio, is slightly better positioned than Rio Tinto. But weaker prices would delay both companies' plans to cut down their debt and return more money to shareholders. So BHP and Rio might not be right in playing down the slump in iron ore prices.

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Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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