--Clyde Russell is a Reuters market analyst. The views
expressed are his own.--
By Clyde Russell
LAUNCESTON, Australia, July 18 Ramping up output
in the face of an expected easing in demand growth may seem like
an odd tactic for a miner, but it's exactly what Rio Tinto
and BHP Billiton are doing in iron ore.
The world's second- and third-ranked producers both said
this week that their expansion plans are on track,
notwithstanding the expected slowdown in China, which buys about
two-thirds of global seaborne iron ore supply.
But there is method in the seeming madness of increasing
production when the demand outlook is less than rosy.
Both Rio and BHP are effectively betting that their low-cost
operations in Australia will be able to dominate the market,
squeezing out both Chinese domestic production and higher-cost
mines elsewhere in Australia and around the globe.
They are also betting that the fears of a slowdown in
Chinese demand growth are being overstated, and that import
volumes will remain healthy.
While these may look like risky assumptions for the two
Anglo-Australian mining giants, they stand a good chance of
The cost of production for both Rio and BHP is around $50 a
tonne, meaning a profit of more than $80 at the prevailing Asian
spot price of $130.40.
Even if iron ore does fall sharply in the second half of the
year on the back of slowing demand growth in China, BHP and Rio
would likely be the last profitable producers standing.
And there aren't too many analysts tipping a decline similar
to what happened in the third quarter of last year, when spot
prices plummeted by more than 20 percent to reach a three-year
low of $86.90 a tonne in early September.
The consensus is centred around levels between $110-$120 a
tonne, with downside risks.
If this does prove accurate it means that Rio and BHP are
making the right decision to chase volumes, as they will still
be making bigger margins than their competitors.
The iron ore market in China, and indeed globally, is also
dissimilar to other bulk commodities such as copper and crude
oil insofar as there is very little capacity, or willingness, to
build large inventories.
Miners, traders and steel mills all work on relatively tight
inventories, meaning that supply tends to adjust to demand more
quickly than in some other commodity markets.
In times of oversupply, this means output tends to be cut
and past experience suggests that the first to be idled are
high-cost, low-grade Chinese mines, and the last are BHP and
Rio's Western Australian mines, as well as those of Brazil's
It's also worth looking at what is the likely scenario for
Chinese iron ore demand for the rest of 2013.
Imports in the first half were 384.3 million tonnes, a 5.1
percent gain over the same period in 2012.
The median forecast of analysts in a Reuters poll published
July 4 was for imports to total 786 million tonnes for the full
This means that 401.7 million tonnes would have to be
imported in the second half, which hardly sounds like a slowdown
at all, in fact it's more like an acceleration.
The most bearish forecast was for iron ore imports of 736
million tonnes in 2013, just below the record 744 million
reached in 2012.
Even if this pessimistic assessment turns out to be the most
accurate, Rio and BHP would still likely to be able to sell
their increased production because they could afford to undercut
their global rivals and Chinese miners.
BHP produced a record 187 million tonnes of iron ore in the
fiscal year ended June and by December it plans to be running at
an annual capacity of 220 million tonnes.
Rio mined 66 million tonnes in the three months to June, on
track to meet its 2013 guidance of 265 million tonnes. It said
this week that it would lift its annual production capacity to
290 million tonnes by the end of September and to 360 million by
the end of 2014.
These capacity expansions come with big price tags, with Rio
spending an estimated $5 billion on its projects.
It's the combination of huge capital expenditure and
inability to get below BHP and Rio on the cost curve that may
ruin other iron ore projects.
Among those are billionaire Gina Rinehart's $10 billion Roy
Hill project in Western Australia, which is still trying to
secure debt financing and Anglo American's over-cost and
delayed Minas-Rio mine in Brazil.
Ultimately, what appears to be a gamble by BHP and Rio isn't
so much of a risk, because they are playing with the cards
stacked in their favour.
Disclosure: At the time of publication Clyde Russell owned
shares in BHP Billiton and Rio Tinto as an investor in a fund.
He may also own other shares mentioned as an investor in a fund.
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