The iron ore price slump won't stop BHP and Rio

Even as the price of iron ore continues to decline, the economics of ramping up volumes will remain compelling for Rio Tinto and BHP Billiton.

With the iron ore price touching $US70 a tonne overnight, the price is closing in on the point where only Rio Tinto and BHP Billiton will have profitable iron ore businesses. Despite the continuing collapse in the price, however, both remain committed to driving increased production volumes.

Any of the smaller producers hoping for some relief from the apparently inexorable decline in the price to levels below $US70 a tonne -- when the price usually firms in November and December as China’s steel mills build up their stocks -- would have had them dashed by Andrew Mackenzie’s comments at BHP’s annual meeting in Adelaide today.

Mackenzie referred to the 20 per cent increase in the group’s iron production last financial year, a key contributor to the overall increase in group volumes of nine per cent. BHP plans to continue to deliver record production volumes, with the group targeting a 16 per cent increase over the two years to the end of the current financial year.

Rio, of course, is on course to increase its iron ore volumes from 290 million tonnes a year to 360 million tonnes a year. With cash costs of about $US20 a tonne and ‘’all-in’’ costs of about $US40 a tonne, Rio is the low-cost producer in the sector, with BHP not far behind.

In the absence of an unexpected sharp pick-up in China’s demand, the increased volumes pouring out of Rio and BHP’s Pilbara operations will add to the existing surplus of supply over demand.

Estimates of that surplus range from about 60 million tonnes to about 80 million tonnes but, with the rate of growth in China’s demand in the very low single-digits at best, the size of the surplus is set to significantly increase. It could well double next year, hence the emergence of some extreme forecasts of a price at or below $US60 a tonne sometime next year.

Even at the current levels, almost everyone other than Rio and BHP would be losing money. Fortescue might be barely cashflow-positive at the $US70 a tonne level but the halving of its share price since mid-year reflects the market’s assessment of its deteriorating outlook.

Rio and BHP are pursuing the textbook response by the low-cost producers to a major downturn in prices by driving increased volumes to help offset the impact of the lower prices. They are also very focused on continuing to lower costs and boost their productivity.

Over time, their rising volumes will displace higher-cost production in China and elsewhere. The further prices fall and the longer they remain depressed the more of that higher-cost production will disappear from the market permanently.

At present, while some smaller producers have fallen over already, many are hanging on and hoping prices recover. For some it is preferable to continue producing at a loss than face the costs (and the permanence) of closing mines.

The extent of the decline in price and the continuing surge in volumes from Rio and BHP will intensify and accelerate the pressure on the rest of the sector, which in the longer term will strengthen their own position in an iron ore market that they, with Brazil’s Vale, used to dominate.

While Glencore’s Ivan Glasenberg has been critical of their production expansions -- and put his money where his mouth is by temporarily suspending production at Glencore’s Australian coal mines to reduce the extent of over-supply in that market -- the Rio and BHP iron ore businesses remain highly profitable even at the lower prices and the economics of increased volumes remain compelling for them.

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