Okay, lets set this thing up. Less than a decade ago, Chinas economy was growing at 10+%. Now, its more like 7 or 7.5%. Its no coincidence then that between 2010 and 2012, the price of iron ore reached highs of between $160-$180/tonne. Now, however, its trading around US$70/tonne.
Last year iron ore miner Rio Tinto (LSE: RIO) (NYSE: RIO.US) pumped out a record 251 million tonnes of iron ore. The miners still trying to capitalise on the relatively strong demand today. Rio says its currently working on creating capacity for 360 million tonnes per annum. This is happening at the same time as obvious price signals from the market suggest that the heyday for iron ore is actually over.
The other naughty commodity is crude oil. Over the weekend Brent crude slipped under US$70/barrel. The price hasnt been that low for around four years. Many price forecasts at this point are just stabs in the dark but some analysts are now calling a drop to US$60/barrel. Despite oil falling into a bear market, OPEC has indicated it wont take any action to reduce supply (currently around 30 million barrels a day).
Whats going on?
To state the obvious, global demand just isnt there to soak up the level of supply thats currently being generated in both the oil and iron ore markets. With regard to iron ore, its largely a China story. The nation imports two thirds of the 1.2 billion tonnes of iron ore traded annually. In terms of oil, its a US story. Analysts estimate that the US has cut its oil imports by 8.77 million barrels per day since 2006. The worlds largest economy is ever so gradually moving towards tapping its shale resources for energy production. Experts, though, say that squeezing shale oil out of the ground becomes economically unviable when crude oil approaches $60/barrel. It seems OPEC knows this and is prepared to take a bullet to the arm (cop lower oil prices in the short term) rather than a bullet to the heart (by shale gaining more market share).
What does it mean for Rio and BP investors?
City analysts estimate that for every $10 or 6 per tonne drop in the price of iron ore, Rio Tintos annual revenues fall by $2.8 billion. So if the price falls further, investors could see as much as $7 billion knocked off Rios bottom in the medium to long term. In fact, analysts at Citigroup estimate that by as early as 2018 the iron-ore surplus will exceed 300 million tonnes. That has the potential to send the price into the $50/tonne area.
BP faces a similar story. The oil producer says it loses about $275 million in annual pre-tax operating profit when the price of Brent crude drops $1/barrel. However, and thats a big however, its refining business (helped by the lower cost of oil) provides a cushion for its bottom line to the tune of around $500 million in additional operating profit annually.
The so what section
The share prices of Rio Tinto and BP will be under pressure until the markets for both iron ore and oil stabilise. BP has the benefit of being an oil refiner, and having OPEC to manage long-term supply problems in the market. Rio Tinto, on the other hand, may not see a return to those high iron ore prices for some time, if ever. In response, the miner is ramping up production as we speak to make up for the fall in prices counter-intuitive? yes, but the company is desperate to maintain shareholder value and believes higher volumes at lower costs will help margins. If this continues the supply glut will only grow larger and the share price will fall, as will the dividend.
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David Taylor has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.