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Why The Party’s Over For BHP Billiton plc & Rio Tinto plc

In the years after the financial crisis, BHP Billiton (LSE: BLT) and Rio Tinto (LSE: RIO) were two of the FTSE 100‘s star performers. 

Chinese economic growth drove the demand for raw materials to record highs during 2010 — 2012 allowing Rio and BHP to benefit from the boom. From the end of 2008 to 2011, Rio and BHP outperformed the FTSE 100 by 67% and 24% respectively. 

However, nearly four years later and the party seems to be over. 

Indeed, over the past 12 months, Rio and BHP have underperformed the UK’s leading index by 13.3% and 32% respectively. Since the end of Rio and BHP have lagged by 38% and 53%. 

Boom to bust 

The past five years have been a turbulent time for BHP and Rio. From a period of rapid growth in the years immediately after the financial crisis, the two miners have struggled recently. 

Key commodity markets have become oversupplied and prices have plummeted. Rio and BHP’s earnings have followed suit. 

Since the end of 2011, on a dollar basis, BHP’s earnings per share have declined by 63%. Rio’s earnings have declined by 70%. 

Room to grow?

Unfortunately, it seems as if, for the next few years at least, Rio and BHP will be stuck will little to no earnings growth. 

You see, the fortunes of these two companies depend largely upon the price of iron ore.

But iron ore prices are struggling to move higher themselves as the market is plagued with oversupply. This year alone it’s estimated that the iron ore market will be oversupplied by somewhere in the region of 200mt.  

And much of this oversupply has been provided by the likes of Rio and BHP. These two miners have been ramping up production in an attempt to forced high-cost producers out of the market. 

Oversupply 

The result of BHP and Rio’s assault on smaller producers has crippled the entire iron ore market.

During 2014, global iron ore supply expanded by 600m tonnes, triple the pace of new supply added in 2010.

This year, another 600m tonnes of supply is set to come to market. Then, during 2017 another 700m tonnes of supply is forecast to come on stream.

The deluge of iron ore supply will continue into 2018 when 750m tonnes of supply is set to come to market. Over the same period, iron ore demand is only set to increase by 500m tonnes.

So, it’s easy to see that supply will almost certainly continue to exceed demand for the foreseeable future. 

Cash generative giants 

As iron ore prices remain depressed, Rio and BHP will struggle to grow over the next few years. Nevertheless, these two mining behemoths have all the tools at their disposal to weather the storm. 

Indeed, both Rio and BHP are aiming to lower iron ore production costs to under $25 per tonne, compared to the current iron ore price of approximately $61 per tonne. 

With production costs falling, BHP and Rio should be able to consolidate their operations, pay down debt and prepare for a recovery in the iron ore market. 

And investors will be paid to wait for this recovery. 

Top income plays

BHP and Rio are both income plays at present levels. 

Specifically, Rio currently supports a dividend yield of 5% and the payout is covered 1.2x by earnings per share. BHP supports a yield of 5.9% and the payout is once again covered 1.2x by earnings per share.

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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.