The price of the steelmaking ingredient hit a five-year low earlier this week and has continued to decline, settling at $84.30 per tonne last night. All in all, the price of ore has dropped 37.2% in the year to date.
A big problem
For Rio and BHP, the falling price of iron ore is concerning in the short-term, but is actually good news over the longer term.
You see, a$1 drop in the average iron ore price wipes out $135m of annual net profit after tax at BHP Billiton and $122m at Rio. Since the beginning of this year the price of iron ore has dropped by around $30 per tonne.So, these figures suggest that the falling price has cost BHP around $4bn in annual profit, while Rio has lost out on $3.7bn of annual profit.
Unfortunately, these miners have no one but themselves to blame for falling profits. Its expected that due to production increasesthe big four iron ore producers, which include BHP and Rio, 108m tonnes of additional seaborne iron ore supply will hit the market during 2014. Another 108m tonnes will hit the market during 2015.
However, at the same time demand for steel within China is falling as the housing market cools. There is also a significant amount of inventory held at ports around China.
BHP and Rio are actually well aware of how oversupplied the Chinese market is. Nevertheless, as the two mining giants ramp up production to drive down prices, they are driving higher cost peers out of the market.Rio Tinto reckons that 125m tonnes of high-cost iron ore supply will be cut in 2014, mostly in China. Over the long-term this should ensure that the price of iron ore settles at a level around $100 per tonne.
As two of the largest iron ore miners in the world, BHP and Rio have extremely low production costs, so they can weather the low selling price of iron ore. Rio has previously stated thatit is able to produce its Pilbara iron ore at an average price of $21 per tonne,excluding royalties and freight costs. Meanwhile, according to City analysts the price of iron ore only needs to be higher than $45 per tonne for BHP to break even.
Still, if the price of iron ore stays suppressed for a long period, Rios plans toreturn cash to shareholders will be scuppered. In particular, according to City analysts, with iron ore at current prices Rios net debt will hit around $17bn by the end of this year.
However, Rios management has previously stated that it is targeting a mid-teens net debt figure, implying that the company is going to have to cut costs somewhere in order to improve cash flow and pay down debt.
With this being the case, those investors who brought into BHP and Rio for their proposed cash returns could find themselves out of pocket.
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Rupert Hargreaves 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.