The price of iron ore has fallen by around 60% since the start of 2014, when it traded at about $125 per tonne.
However, over the same period, shares in Rio Tinto (LSE: RIO) (NYSE: RIO.US) and BHP Billiton (LSE: BLT) (NYSE: BBL.US) have fallen by less than 15%.
In this article, I’ll explain why I believe both companies remain attractive investments — and why both could be approaching a turning point.
Are commodities bottoming out?
In 2014, 87% of Rio’s earnings came from iron ore, making it clear how closely tied to the iron ore market the firm’s fortunes are.
Iron ore and oil combined accounted for 69% of BHP’s underlying operating profits during the last six months of last year, highlighting the group’s greater diversity — but also its exposure to the oil market crash.
It’s clear that profits will have been hammered at both firms, and given this bleak outlook, you might be understandably cautious about buying shares of either firm.
However, while it’s too early to call the bottom of the iron ore market, both oil and copper — a key commodity for both Rio and BHP — have rebounded steadily in recent months. Copper has gained around 13% since the start of February, while oil prices are more than $20 per barrel higher than the sub-$50 lows seen in January.
It’s just possible that the commodity market is starting to turn.
Cutting hard
Profits don’t just come from higher selling prices — they also come from lower costs.
To help cut costs and improve focus on key assets, BHP shareholders voted on Wednesday on a plan to demerge a range of non-core assets into a separate firm, South32.
At the same time, both Rio and BHP have been cutting costs ferociously over the last six months. According to recent estimates by UBS, Rio and BHP have reduced their iron ore break-even cost to around $35 per tonne, down from between $40 and $50 per tonne in October 2014.
At these levels, I believe both firms should be able to ride out the iron ore bear market quite comfortably, while the firms’ strategy of driving out higher-cost peers takes effect.
Who’s feeling the pain?
One example of a company that’s suffering is Fortescue Metals Group, the world’s fourth-largest producer of iron ore. Fortescue was recently forced to issue $2.3bn of bonds needed to refinance its debts at an interest rate of 10.25%.
In contrast, BHP recently issued €2bn of new bonds with interest rates of between 0.35% and 1.5%, suggesting bond investors continue to see BHP as a very safe bet indeed.
Too soon to say?
Of course, things could get worse. A number of City analysts believe iron ore could fall below $40 per tonne, at which point Rio and BHP’s dividends could come under threat.
However, while that’s a risk, I don’t think it’s likely. Demand hasn’t collapsed, and Rio and BHP remain the most profitable iron ore producers in the world.
In my view, both firms are currently attractive income buys, with good long-term growth potential.
