There is one obvious similarity between what’s happening with oil and what’s happening with iron ore. The price of both commodities has plummeted. Oil is down 50% since last July. Iron ore is down 50% since the start of 2014.
But there is a second similarity that isn’t quite so obvious, but that could provide a valuable insight for investors.
Expansion in supply driven by the shale revolution in the US has driven down the oil price. Unusually, the big, low-cost producers of oil — the Saudis — haven’t cut back production to stabilise prices. Instead they appear intent on forcing out the higher-cost US producers through a period of uneconomic prices.
Weaker demand from China has been the main factor behind the drop in iron ore prices, but increasing production plays a part as well. It’s the way of commodity cycles, especially those with long lead times, that production gears up in anticipation of rising demand, only to come on stream as it starts to decline.
Surprise
But the surprising thing is that the big, low-cost producers of iron ore are continuing to increase capacity. BHP Billiton (LSE: BLT) (NYSE: BBL.US) is doubling production at its newest mine, Jimblebar, and planning to ramp up capacity further. Rio Tinto (LSE: RIO) (NYSE: RIO.US) is expanding its giant Pilbara mine. The world’s largest iron ore exporter, Brazilian miner Vale, and the number four, Australian Fortescue, are both boosting production as well.
But as numbers two and three of the big four producers, Rio and BHP are the best placed to endure sustained low prices. Last year UBS estimated their break-even costs at $44 and $53 per tonne respectively, compared to $76 and $77 for Vale and Fortescue.
It’s a strategy not without pain. It’s curtailing the miners’ ability to return cash to shareholders, and it’s been widely criticised. This week, the CEO of Cliffs Natural Resources said it could lead to “Australia going out of business”. The smaller OPEC members might have similar objections.
The long game — for investors
Like the Saudis, the big miners are acting against their best short-term interests, playing a long game aimed at forcing out higher-cost producers – especially Chinese domestic supply. In the long run they believe they will economically benefit: if they’re right, then so will investors in BHP and Rio. The effect of operational gearing means that when prices eventually rise, their profits will rocket – along with share prices.
I’m not calling the end of the bear market in mining shares. Market timing is notoriously difficult. But if you’re putting money away for the long term — topping up an ISA maybe — then they look good stocks to invest in for capital appreciation. That’s especially true if you reinvest the generous 5%+ yields on offer.
