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BHP Billiton Ltd Shows No Mercy for Weaker Producers

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As iron ore and met coal markets remain oversupplied, most producers are hoping for production cuts. However, they can expect no mercy from BHP Billiton (NYSE: BHP  ) , which has recently increased its full-year production guidance for both iron ore and met coal. The company has raised its iron ore production outlook by another five million tons to 217 million tons. In addition, its met coal production guidance was raised to 43.5 million tons.

Rio Tinto is also growing production
Another big player, Rio Tinto (NYSE: RIO  ) , also adds to excess supply. Rio Tinto's iron ore production rose 8% in the first quarter of 2014 compared to the first quarter of 2013, while met coal production was up 14%. These numbers look big given Rio Tinto's size, but BHP Billiton's production growth rates are even bigger. The company grew its iron ore production by 23% and met coal production by 28% compared to the first quarter of 2013.

With such production growth rates, there is little chance for upside in iron ore and met coal markets in the near term. There are signs that weaker producers begin to close high-cost mines, but these cuts are easily offset by the production growth from world's biggest producers. For example, Walter Energy (NASDAQOTH: WLTGQ  )  recently decided to idle production at its Canadian mines. The situation on met coal market will improve only if other producers will follow Walter Energy's example. Until now, producers were hesitant to close uneconomic production.

Cliffs Natural Resources could follow Walter Energy's example
Cliffs Natural Resources (NYSE: CLF  ) is a company that could follow Walter Energy's path. Cliffs Natural Resources' costs at its Canadian iron ore mines are significantly higher than costs at its U.S. and Australian operations. Lately, Cliffs Natural Resources was under pressure from activist investor Casablanca Capital, and prolonged softness in iron ore prices could force the company to take decisive actions in order to please its investors.

Importantly, Cliffs Natural Resources is also a producer of met coal, so the company's margins are squeezed on both fronts. Cliffs Natural Resources recently decided to delist from Euronext Paris in order to cut costs, but this was a minor step. Investors can't be happy with the performance of the company's shares, which are down 28% year to date, and demand more action from the company. Idling some of its Canadian mines will be a much bigger move in cost management than delisting from Euronext Paris.

Big miners are better positioned for low-price environment
BHP Billiton and Rio Tinto continue to follow their strategy of gaining market share through increased production. At current price levels, they could easily afford it. Yet, their margins are being squeezed as well, so we can expect slower production growth rates from both miners in the near future.

Low iron ore and met coal prices make a lot of production uneconomical. However, this production is slow to exit the market, as producers wait too long before quitting and continue running operations with negative cash flows. This hesitance is costly. When a producer decides to idle a mine, iron ore or met coal reserves don't disappear and could be used when the price environment is more favorable. The sooner companies understand this simple truth, the better for the overall market. 

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Vladimir Zernov

Vladimir Zernov believes that fundamental analysis works best with energy and materials stocks and covers them on Motley Fool.

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8/28/2015 4:02 PM
BHP $36.69 Up +0.69 +1.92%
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