Since peaking around February 2010, the price of iron ore has plunged by 70% or so, and we need to look back around six-and-a-half years for when it lasttraded as lowascurrent prices.
Does that matter to these diversified enterprises?
Both these mining giantscommit a large amount of their efforts to producing iron ore. At the last tally, BHP Billiton earned around 50% of its profits from the raw product. Rio Tinto is in deeper still, depending on iron ore for almost 90% of its earnings.
So the continuing slide in prices is of major concern. The strategy of both firms is to ramp up iron ore production whilst bearing down on production costs, in what looks like a dash for market share.
The hope must be that market-share gains will eventually squeeze out competition. If BHP Billiton and Rio Tinto can use economies of scale to produce iron ore cheaper than smaller operators, maybe their market dominance will enable a profit-drive later.
Aggressive tactics aimed at securing market share seem to be the strategy of the day in other arenas too. Within the commodity sector, we see a similar situation playing out inthe oil market. And then theres the battle for customer loyalty that is raging in the supermarket sector.
BHP Billiton reckons it will slash its iron ore production cost further and reduce its capital and exploration expenditure to $9 billion during 2016, from $12.6 billion in 2015, as growth projects mature. The firm is slugging it out hard with its rival Rio Tinto. The eventual winner will be crowned the lowest-cost iron producer.
Victory in such a contest could be pyrrhic. Arguably, faced with the possibility of profit collapse in their biggest markets, BHP Billiton and Rio Tinto could have jumped the other way with a programme of retrenchment and project closedown. Perhaps then, with reducing reliance on one over-weighted commodity, the benefits of diversification could have filtered into their volume-reduced trading results.
BHP Billiton Chief Executive Andrew Mackenzie recently dismissed criticism that a strategy of production increases only fuels the sharp slump in iron ore prices. He argued that the firm operates in highly competitive and cyclical markets, where earnings out-performance through the cycle depends on being the most efficient supplier, not on supply restraint. He reckons BHP Billiton is well prepared for the possibility of an extended period of lower prices in several commodities, not just in iron ore.
Why should we invest?
A lower Australian dollar against the US dollar, and lower oil prices, has helped both firms with their cost-cutting efforts. But Andrew Mackenzies comments bother me. If these companies are hunkering down for a protracted period of lower prices, why should we invest?The timing seems bad.
If we look ata 20- or 30-year price chart for iron ore, the last 10 years during the so-called super-cycle craze looks like nothing more than a bubble. Iron ore and other commodities could have much further to fall and, once down, the prices could stay there again for decades.
For me, the risk of investing in big mining firms such as BHP Billiton and Rio Tinto remains too great and the shares are unattractive. Instead, I’m looking at firms likely to benefit from lower commodity prices such as these businesses with strong trading franchises. You can find out why the Motley Fool’s analysts rate these firms so highly by clicking here.
Kevin Godbold 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.