|Summary: BHP Billiton and Rio Tinto both have major iron ore operations, but the mining giant twins are far from identical. While Rio generated 80% of its pre-tax earnings from iron ore last year, for BHP the contribution from iron ore was only 49%. Most of the rest came from its oil and gas operations.|
|Key take-out: BHP’s lesser reliance on iron ore makes it a more attractive proposition than Rio, especially if ore prices drop further.|
|Key beneficiaries: General investors. Category: Growth.|
Many investors treat BHP Billiton and Rio Tinto as if they were twins because both fit into the “diversified resources” category.
However, as with human twins, one can be more talented than the other. This is why BHP Billiton has drifted into buy territory, but Rio Tinto remains a sell.
Two assets mark the difference between the companies. BHP Billiton has a resurgent oil and gas division. Rio Tinto remains too heavily exposed to iron ore.
Over the next year, if current trends continue, the “twins” could be separated by a value gap that can already be seen in the remarkable recovery in US gas prices and the current slip in iron ore prices.
If iron ore does drop sharply from its current $US137 a tonne to $US80/t, as some analysts are forecasting, it will challenge all producers of the steel-making material, especially smaller and higher-cost miners such as Fortescue, Mt Gibson, Grange, Atlas, and BC Iron.
But, at the top end of the resources sector, the biggest loser from a sustained fall in the iron ore price will be Rio Tinto, which last year relied on its iron ore operations to generate a remarkable 80% of its pre-tax profit.
BHP Billiton is far less exposed to a commodity that has started a long-predicted cyclical downswing. In the December half-year, BHP Billiton generated 49% of its pre-tax earnings from iron ore, and 32% from oil and gas.
Looking ahead, both big miners will feel the squeeze on their iron ore operations. However,both are also well positioned as the low-cost leaders to comfortably survive the downturn, and to prosper as higher-cost and small miners are pushed out of the industry.
The difference that will separate Rio Tinto from BHP Billiton is oil and gas, with the US domestic gas price having risen by a massive 85% over the past 12 months to a two-year high of $US4 per million British thermal units.
At that price, which is a result of soaring demand for gas in the US and the producer cutbacks that occurred when the price fell below $US2/mbtu, BHP Billiton can start to increase production from gasfields it mothballed in the downturn. These are the same gasfields which forced it to take a $US2.84 billion asset-value write-down last financial year.
Hints have already been dropped that BHP Billiton is preparing to boost US gas production, with the head of its petroleum division, Mike Yeager, telling a conference in the US oil capital, Houston, last month that a gas price above $US4/mbtu would justify lifting production from its gas assets in the Haynesville and Fayetteville shale formation.
When Yeager said that, on March 6, the US gas price was around $US3.50/mbtu. At the end of last week, gas prices moved above $US4/mbtu for the first time since September 2011, thanks to rising demand and a stronger-than-expected recovery in the US economy.
Gas up, and iron ore down, will expose the earnings differences between BHP Billiton and Rio Tinto, and while there are divided opinions on the outlook for iron ore it is a commodity that will affect both companies equally. Only BHP Billiton will benefit from rising gas prices.
First signs that the two resource leaders, which have a place in most Australian investment portfolios, were starting to track in different directions could be seen earlier this year in the way they replaced their chief executives.
BHP Billiton’s swapping of Marius Kloppers for Andrew Mackenzie was a surgical operation that has had little impact on the day-to-day operations of the company.
Rio Tinto’s “man overboard” experience with the sacking of Tom Albanese, and his rushed replacement with a 63-year-old “temp” in Sam Walsh, has panic written all over it. This is not least because of the excess focus on iron ore, but also because of unresolved problems in other operations including a dispute with the government of Mongolia over the Oyu Tolgoi copper mine and a dispute with the government of Guinea over the Simandou iron ore project.
Walsh might be a competent pair of hands to guide Rio Tinto through a rough patch until a younger successor can be found, but he has inherited a business that is in danger of forfeiting its diversified tag by being excessively exposed to a single commodity (iron ore), which has a falling (not rising) price.
Analysts at some investment banks have been slow to recognise the divergence underway between BHP Billiton and Rio Tinto, or the speed at which the cyclical downturn in iron ore prices is arriving, and the influence that will have on all iron ore miners.
Last week saw a significant difference of opinion emerge between leading investment banks on Australia’s third-biggest iron ore miner, Fortescue.
JP Morgan upgraded its recommendation on Fortescue from Neutral to Overweight, boosting its 12-month price target from $4.70 to $4.95. Goldman Sachs retained a Neutral view of Fortescue and downgraded its price target by 13% to $4.10.
In those two opinions lies a differing view of the iron ore market. Goldman’s view is encapsulated in its report titled: “Iron ore; the end is nigh-er than we thought”. JP Morgan’s view is best illustrated by an ANZ Bank view of the market titled: “Bearish tone in iron ore overdone”.
Our own Adam Carr would be much closer to the ANZ point of view, indeed he might even be more bullish. Adam believes the entire story behind the ‘iron ore price is set to sink’ consensus is wrong, (click here to see the full story) but I would prefer not to take the risk ... and certainly not with Rio.
Dramatically different views of the same industry by big-name stockbrokers and banks does not make life easy for investors managing their own portfolios, because if one side of the debate is right the other must be wrong.
My view, first expressed in a February 18 story on Eureka Report, was contained in the headline: “Rio’s rotten run may not be over yet”. It was a snappy description that captured the toughening outlook for iron ore and the deep-seated problems in a number of the company’s other operations.
On that day, Rio Tinto’s share price closed at $70.89. It closed yesterday at $56.50, a fall of 20% in roughly six weeks.
BHP Billiton, buffeted by the same commodity-market headwinds, has fallen over the same time from $38.67 to $32.72, a decline of 15%. That 5% gap is a clue as to the way the two companies will perform in the future.
As for differing views on iron ore, ANZ argues that demand for steel in China will remain strong despite government efforts to curb high-rise property developments. The bank has forecast an iron ore price of $US132/t in the second-half of 2013, down modestly from a previous forecast of $US141/t.
Goldman’s view is that the iron ore price will slide at an accelerating pace, from $US139/t this financial year to $US115/t next year, and then down to $US80/t in 2015 – a result of changes in the Chinese iron and steel market and rising worldwide iron ore supply.
“The key drivers (of the iron ore market) are increasing scrap usage in China, Chinese (iron ore) production to surprise on the upside, and lower steel production,” Goldman said.
“The result is a market surplus from 2014 onwards, driving prices towards the marginal cost of seaborne supply.”
If that 2015 Goldman price forecast for iron is correct, some of the smaller and higher-cost miners will be forced to mothball their mines because the $US80/t is not what they get. After discounts for ore quality and impurities, some Australian miners will be getting close to $US60/t – with that price also subject to exchange-rate fluctuations.
The tipping game for some of the stocks with significant exposure to iron ore looks like this:
- BHP Billiton: UBS, Goldman Sachs and Deutsche Bank say buy. Credit Suisse, JP Morgan and Commonwealth Bank are neutral, and BA Merrill Lynch says “underperform”, which is code for sell.
- Rio Tinto: JP Morgan, Citi, Deutsche, BA Merrill Lynch, Credit Suisse and Commonwealth Bank say buy. Goldman Sachs and Macquarie Equities are neutral.
- Fortescue Metals: JP Morgan, Credit Suisse, CIMB Securities and Citi say buy. Goldman Sachs says hold, and Deutsche says sell.
- Atlas Iron: Credit Suisse and UBS say buy. Macquarie, CIMB and Citi are neutral.
- Mt Gibson: Deutsche and CIMB say buy. UBS and Credit Suisse are neutral. BA Merrill Lynch says underperform.
- Grange Resources: UBS, JP Morgan and Macquarie are neutral. BA Merrill Lynch says sell.
- Gindalbie Metals: Credit Suisse and Citi are neutral. JP Morgan and BA Merrill Lynch say underperform.
Interesting as those views are on the iron ore sector, the point about the two dominant producers is that one, Rio Tinto, is excessively exposed to a mineral that could fall very sharply over the next two years. The other, BHP Billiton, will suffer to a lesser extent because of its more diverse portfolio, plus it has the added benefit of an oil and gas division at a time of rising US gas prices.
The net result: Buy BHP Billiton. Sell Rio Tinto.