Have BHP Billiton plc And Rio Tinto plc Burst The Iron Ore Bubble?

Last week the price of iron ore crashed to a five-year low of $70 per tonne, prompting comments from Glencore’s CEO, Ivan Glasenberg, that BHP Billiton (LSE: BLT) (NYSE: BBL.US) and Rio Tinto (LSE: RIO) (NYSE: RIO.US) have killed the commodity supercycle. 

Unfortunately, Rio and BHP don’t appear to be considering a change of heart any time soon. Last week Rio announced another mine in Western Australia and BHP has updated its plans to reduce production costs, in order to compete more effectively with Rio.

Indeed, the world’s largest miner has announced this morning that it will trim $600m from planned capital spending, to $14.2bn for the 2014-15 financial year, and by $1bn to $13bn for the following year. Further, the group plans to excise an extra $500m of cost cuts. Management is now targeting $4bn per annum in productivity gains by 2017. 

Going to get worse

As BHP and Rio struggle to cut costs to maintain profit, output is still rising and as a result, the market is becoming extremely over supplied. For example, Goldman Sachs estimates that 165m tonnes more iron ore will be mined next year than the market needs, which has prompted some City analysts to suggest that the price of iron ore will fall further to $65 per tonne. 

$65 per tonne could be considered to be the danger zone for many miners, even BHP and Rio. Indeed, even though figures suggest that Rio and BHP can produce iron ore for $20 to $50 per tonne, other costs such as shipping and debt interest are not included. 

Moreover, shareholder returns — which were promised by BHP and Rio last year — are now unlikely to materialise as profits collapse. In particular, City analysts have estimated that a $1 drop in the average iron ore price, wipes out $135m of annual net profit after tax at BHP Billiton and $122m at Rio.

As the price of the key steel-making commodity has dropped by around $65 per tonne, from the $135 mark seen at the start of the year, it’s reasonable to assume that BHP and Rio have seen nearly $8bn and $9bn respectively of potential profit wiped out. This could cause some trouble.

Killing it 

With profits evaporating and production still rising, it’s easy to conclude that Rio and BHP have burst the iron ore bubble but, as mentioned above, the price of the commodity could fall further still. 

And it remains to be seen if these miners will realise their mistake. Ivan Glasenberg has made it quite clear the he does not agree with BHP’s and Rio’s tactics. In fact, Glasenberg is so disappointed with Rio that he’s considered taking the company over and scrapping development plans to stop the miner killing the iron ore market.

Long-term play

Still, with the industry's lowest iron ore production costs, Rio and BHP can afford to ride out a weak market for some time. For long-term buy and forget investors, the two miners remain great picks. 

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.