The Latest Salvo in the Iron-Ore Price War

Investing Daily Article of the Week

by Ari Charney, Investing Daily

Although the outlook for iron ore remains gloomy, it appears the price of the base metal has finally found a bottom.

Following a medium-term peak in December 2013, iron ore spent the next 14 months steadily declining until it hit a low of $61.76 per metric ton on Feb. 9. And while the metal has barely budged off that low since then, that level has managed to hold.

The 14 institutional analysts who have updated their models since the beginning of the year forecast that iron ore will trade at an average price of $71.48 per metric ton for full-year 2015. And the following year, the price is projected to trade at an average price that’s only slightly higher, at $76.05 per metric ton.

With expectations so muted, miners are now essentially stuck in an endurance contest, where only the biggest and strongest will survive. However, even an industry’s top companies aren’t immune to suffering during a downturn.

Evidence of that came earlier this week, when BHP Billiton Ltd. CEO Andrew Mackenzie told analysts during a conference call that he fears the company’s

“competitors have an awful lot more capital waiting in the wings to invest in expanding.”

And given that outlook, he acknowledged that he sees further downward pressure on iron ore prices.

At the same time, that’s a consequence of BHP Billiton (ASX: BHP, NYSE: BHP) and fellow mining giant Rio Tinto Ltd. (ASX: RIO, NYSE: RIO) ramping up production to sideline higher-cost producers and capture more market share.

During the fiscal first half of 2015 (ended Dec. 31), BHP’s operating income from its iron-ore segment fell 35.4% year over year, to $4.2 billion. And while the company is diversified across what it calls its “four pillars” of iron ore, petroleum, copper and coal, iron ore still accounted for nearly 50% of its overall operating income.

As a result, adjusted earnings per share dropped 38% year over year on a 12% drop in revenue. Still, it could have been worse. The company only missed analyst estimates by 1.1% on earnings per share and by 2% on revenue.

For the full fiscal year, analysts forecast earnings to fall by 37%, while sales are projected to decline by 14%. And for fiscal-year 2016, the company is expected to essentially tread water, before it finally rebounds the following year.

Rio Tinto is also somewhat diversified, with operating segments that produce iron ore, aluminum, copper, and diamonds. But like BHP, Rio’s iron-ore segment delivers the lion’s share of profits, accounting for 67.5% of the company’s EBITDA (earnings before interest, taxation, depreciation and amortization) for the fiscal second half of 2014 (ended Dec. 31).

Rio’s earnings per share for the recently ended period dropped 30% year over year, while sales fell by 13%. For full-year 2015, analysts forecast adjusted earnings per share will decrease by 23%, on a decline in revenue of 9%. A moderate rebound is expected the following year.

Despite these alarming statistics, both companies have very low costs of production, which means they’re well equipped to endure the rout. And both have been pursuing cost-cutting measures and other efficiencies to further pare production costs.

BHP reported that production costs at its iron-ore mines in Western Australia fell to $20.35 per metric ton during the most recently ended period, down 29.3% year over year.

Meanwhile, Rio managed to lower its cost of production for iron ore to just $18.70 per metric ton, down 8.3% sequentially.

BHP says production for full-year fiscal 2015 is on track to reach 245 million metric tons, up 9.2% year over year. And Rio expects to ship 350 million metric tons this year, an increase of 15.7% from the prior year.

While BHP has obviously made enormous headway in reducing costs, analysts expect Rio to continue to maintain its lead as the low-cost producer.

Deutsche Bank analyst Paul Young told The Sydney Morning Herald:

“There are still structural differences between the two businesses where Rio has the upper hand. On the cost line, Rio has more upside on profitability through economies of scale and automation, and their ports are cheaper,” he continued.

Nevertheless, he believes both producers could eventually reduce their costs to $15 per metric ton, if oil prices remain at current levels and the exchange rate falls even further.