I’ve been sceptical about FTSE 100-listed mining giants BHP Billiton (LSE: BLT) (NYSE: BBL.US) and Rio Tinto (LSE: RIO) (NYSE: RIO.US) for some time.
I was particularly concerned that their policy of pumping up production to record levels in the face of falling demand could ultimately backfire.
I was a lonely voice at the time, with the market driving their share prices higher, as a reward for big improvements in productivity and cash flow. Slowly, I think the market has come round to my point of view.
Hard-ish Times
Investors in BHP Billiton and Rio Tinto grew fat on expectations of a commodity super-cycle, thanks to voracious demand from China and other emerging markets for iron ore, copper and other metals and minerals.
But this also left these stocks vulnerable to a Chinese hard landing. China hasn’t crashed, but it is no longer a smoothly oiled growth machine. Industrial output has just disappointed, up just 6.9% in August, against expectations of 8.8%.
Maybe a revived US housing sector could make up the slack. Europe certainly won’t.
So who is going to mop up record levels of production?
The Mackenzie Break
Earlier this year, BHP Billiton chief executive Andrew McKenzie was talking up a 19% rise in iron ore production and 22% leap in metallurgical coal.
Its recent full-year results showed the company exceeding production guidance for a number of core commodities, including iron ore, metallurgical coal and petroleum liquids.
Similarly, Rio’s Q1 results showed a 17% rise in copper production, and big numbers on bauxite. Recent first-half results continued the trend, with record copper and thermal coal production.
Surely, soaring supply combined with flagging demand can only send prices in a downward direction?
Production And Productivity
Recent share price performance suggests there are grounds for concern. Rio is down nearly 9% over the last month, despite its a ringing 21% increase in first-half earnings.
BHP Billiton is down almost 12% over the same period, despite unearthing £8.1bn in free cash flow.
But the two companies have also been canny. BHP Billiton hasn’t just been upping production, it has also been boosting productivity, delivering $6.6bn of sustainable productivity-led gains over the last two years.
Similarly, Sam Walsh at Rio Tinto has achieved $3.2bn of sustainable operating cash cost improvement since 2012, and forecasts a further $1bn worth of savings by the end of 2015.
Rising productivity should certainly offset some of the damage caused by falling commodity prices, which has seen iron ore crash 40% this year, and LME copper fall 7.5% (it has recovered lately).
But it will also worsen the supply glut. If more producers ramp up production to offset falling prices, it could trigger a nasty downward spiral.
Cycles And Super-Cycles
Yet I wouldn’t offload either stock right now. Recent share price falls means you can buy them at much more attractive valuations.
Rio now trades at just 9.4 times earnings and yields a healthy 3.71%. You can buy BHP Billiton at 11.56 times earnings, with a yield of nearly 4%.
Chinese demand is slower than it was, but growth is shifting to the second phase of its growth cycle, towards further consumption and urbanisation, and this should boost demand for copper, tin and graphite.
This year’s iron ore plunge is partly a reaction to overproduction a couple of years ago, as producers looked to cash in on a spike in prices. As more mines come off stream, production is likely to fall, and the cycle will move into recovery phase.
BHP Billiton and Rio may fall further, but they will rise again. In the meantime, admire those shiny dividends.
