COLUMN-BHP, Rio gamble on iron ore, but they’ve stacked the deck – by Clyde Russell (Reuters U.S. – July 18, 2013)

Clyde Russell is a Reuters market analyst. The views expressed are his own.

LAUNCESTON, Australia, July 18 (Reuters) – Ramping up output in the face of an expected easing in demand growth may seem like an odd tactic for a miner, but it’s exactly what Rio Tinto and BHP Billiton are doing in iron ore.

The world’s second- and third-ranked producers both said this week that their expansion plans are on track, notwithstanding the expected slowdown in China, which buys about two-thirds of global seaborne iron ore supply.

But there is method in the seeming madness of increasing production when the demand outlook is less than rosy. Both Rio and BHP are effectively betting that their low-cost operations in Australia will be able to dominate the market, squeezing out both Chinese domestic production and higher-cost mines elsewhere in Australia and around the globe.

They are also betting that the fears of a slowdown in Chinese demand growth are being overstated, and that import volumes will remain healthy. While these may look like risky assumptions for the two Anglo-Australian mining giants, they stand a good chance of being correct.

The cost of production for both Rio and BHP is around $50 a tonne, meaning a profit of more than $80 at the prevailing Asian spot price of $130.40.

Even if iron ore does fall sharply in the second half of the year on the back of slowing demand growth in China, BHP and Rio would likely be the last profitable producers standing.

And there aren’t too many analysts tipping a decline similar to what happened in the third quarter of last year, when spot prices plummeted by more than 20 percent to reach a three-year low of $86.90 a tonne in early September.

The consensus is centred around levels between $110-$120 a tonne, with downside risks.

If this does prove accurate it means that Rio and BHP are making the right decision to chase volumes, as they will still be making bigger margins than their competitors.

The iron ore market in China, and indeed globally, is also dissimilar to other bulk commodities such as copper and crude oil insofar as there is very little capacity, or willingness, to build large inventories.

Miners, traders and steel mills all work on relatively tight inventories, meaning that supply tends to adjust to demand more quickly than in some other commodity markets.

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