--Clyde Russell is a Reuters market analyst. The views expressed are his own.--
By Clyde Russell
LAUNCESTON, Australia, July 18 (Reuters) - 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 being correct.
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 Vale.
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 year.
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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