Over the past week, both Rio Tinto and BHP Billiton have produced strong production growth across their key commodities. Unhappily, however, that news has coincided with a sharp downwards break in iron ore prices.
Last week, Rio’s annual production report showed record production in iron ore, bauxite and thermal coal. For Rio it’s all about iron ore, given that the division completely dominates its profitability.
Today, BHP Billiton’s December-half report also revealed record iron ore and metallurgical coal output and, driven by a 72 per cent increase in production from its US shale gas business, a nine per cent rise in the output from its petroleum business.
The challenge for both groups and their peers is that while their volumes might be surging, commodity prices, already well off their highs, are softening again.
In particular the iron ore price, critical for Rio and important for BHP, has broken through what had been a quite stable floor last year, when it averaged about $US135 a tonne, and has been trading at just under $US125 a tonne.
While that appears to reflect some softening in China’s demand for steelmaking commodities, the big and continuing volume increases from the bid seaborne iron ore producers are outstripping the underlying growth in demand and the surplus of supply over demand that some analysts have been forecasting for quite some time appears to be looming ahead. Recent forecasts see the price continuing to slide through this year and next.
The impact of price declines on the big resource companies’ earnings is far more pronounced than any volume gains. In the first half of 2013, for instance, Rio attributed $US359 million of earnings to volume effects while saying that lower prices had cost it $US1.3 billion.
It isn’t just iron ore prices. Oil prices have also softened (although BHP would be encouraged by the stronger US domestic gas prices) and coal prices are well down on their levels a year ago – levels which pushed most thermal coal producers either into loss or, at best, near breakeven levels. BHP’s report showed that the average realised prices for its metallurgical coal in the December half of last year were down 18 per cent on the same half of 2012 and thermal coal prices 11 per cent.
The weaker prices can only heighten the already intense focus of BHP, Rio and their peers on costs and on the productivity of their capital.
Both the big Anglo-Australian resources groups are successfully stripping billions of dollars a year from their cost bases, while rationing new investment and, where possible, selling lower-returning assets. Despite that BHP is still on track to invest another $US16.1 billion this year.
There is growing confidence that BHP’s Andrew Mackenzie and Rio’s Sam Walsh can deliver on their promised savings and reduce the capital intensity of their businesses while still growing volumes over their more productive platforms over the next few years.
The key question, particularly if iron ore prices were to fall further, however, is whether they can do enough quickly enough to at least soften the impact of lower prices and allow them to deliver the improved cash returns to shareholders that their institutional shareholders have been lobbying for.