Mining Giants Taking a Long-Term View of the Iron Ore Market

Rio Tinto (NYSE: RIO  ) this week released its first half production results. The results showed that the Anglo-Australian miner's iron ore production rose 10% in the first half. Iron ore production at another Australian miner Fortescue also rose sharply. Vale (NYSE: VALE  ) and BHP Billiton (NYSE: BHP  ) , the other two iron ore majors, have also been ramping up iron ore production. At the same time, though, iron ore prices have slumped below $100 per ton on an anticipated supply glut. The big four iron ore miners, however, remain determined to increase production. Their strategy is simple. Lower prices will drive out high cost miners, enabling iron ore majors to increase their market share. By the time the iron ore market rebalances, majors would be in a strong position to capitalize. The strategy would benefit miners in the long term, but would inflict pain in the short term in the form of reduced cash flows and shareholder distributions.

Rio's surging production
Sam Walsh, CEO of Rio Tinto, noted this week that the company achieved another half of very strong performance, driven by productivity gains across business. Walsh further said that Rio's iron ore expansion continues to deliver high-margin growth reinforcing the company's position as a low-cost producer.

Rio's global iron ore production rose 10% in the first half of 2014 to 139.5 million tons. The company's global shipments also rose to a record in the first half. In Pilbara, the company's production rose 11% on a year-over-year basis. Rio Tinto remains on track to achieve full-year production of 295 million tons.

Rio's Australian rival Fortescue, which is the world's fourth-largest miner by volume, also saw its production surge. BHP Billiton, which is scheduled to report its production later this month, has also been ramping up production.

The expansion is continuing even as iron ore prices have dropped below $100 per ton. In June, prices slumped to $89 per ton before stabilizing. Iron ore prices, as I have noted in previous articles, have come under pressure due to an anticipated supply glut in the seaborne market. Producers have been increasing production after demand exceeded supply for many years. Last year, iron ore was one of the few commodities to rally, driven by demand from China. But just as production has increased, demand from China is expected to slow down as the world's second-largest economy moves from export and investment-led growth to consumption-led growth.

Iron ore majors' strategy
Although iron ore prices have fallen sharply this year, iron ore majors are still enjoying healthy margins. Rio Tinto and BHP Billiton have the lowest costs among iron ore miners. While Vale's costs are higher, the Brazilian company can remain profitable even if prices were to fall to $80 per ton. Iron ore majors can sustain lower prices for a considerable period. However, lower prices would drive out high cost miners in China and elsewhere. This is what majors are hoping for.

Iron ore majors are betting that lower prices would lead to the shutdown of high-cost mines, especially in China. They can then move in and increase their market share. And once the market rebalances, they would be in a position to capitalize. Indeed, mining giants are taking a long-term view of the market.

The strategy, though beneficial in the long term, would certainly inflict pain in the short term as miners will see reduced cash flows. That would hamper their ability to cut down debt and increase shareholder distributions. As I noted in an article last week, Rio Tinto and BHP are not likely to be in a position to buy back shares in the near future. Miners are certainly creating value for shareholders in the long term by ramping up production even in a low-price environment. However, the strategy will lower shareholder returns in the short-term. 

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Varun Chandan

I have a Master in Finance degree from IE Business School in Madrid. I use the top-down approach when it comes to investing. I like to analyze macroeconomic factors and how they impact individual companies.

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