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Iron ore: Yes, the juice is bitter

The competition is fierce among the top iron ore miners to drive down costs. In recent days BHP Billiton has touted its plan to usurp all – Rio Tinto in particular – as the lowest cost miner of iron ore, which is the main ingredient in steel making.

The miner is hosting analysts in Australia to hear its production plans which are, like its main rival, to produce more iron ore more cheaply in a market already in oversupply. Indeed, Jimmy Wilson, President of BHP’s iron ore unit, has likened it to squeezing as much juice from a lemon as possible.

The efforts are admirable but defensive. Four titans of iron ore – BHP, Rio Tinto, Vale and Fortescue – account for about half of the market’s supply and among these BHP and Rio Tinto produce iron ore cheapest. Rio Tinto comes first with very basic operating costs somewhere just under $21/tonne iron ore. BHP Billiton is next with operating costs at about $27/tonne. Vale and Fortescue come thereafter.

Now BHP wants to beat Rio Tinto on operating costs. Wilson said BHP aimed to be the “lowest all in cash cost supplier of iron ore to China” in a Monday presentation to analysts and has a $20/tonne figure in mind. Next year the company aims to come under $25/tonne.

It’s all quite notable. But it’s the price of iron ore that makes this lemon wringing exercise exceedingly bitter. The savings come in a market where prices have plummeted month after month.

The price for 62{f3b888cd21f4f097cf256c2abf48fb4da5e46c34da410c05974afd2e97e2de2a}-iron-ore fines for example is now well under $100/tonnes after having spent the past half decade far above that mark (see chart below) – at times near $200/tonne. BHP, along with other miners reducing costs, is really just making the best of bad (or more fairly worse-than-it-was) situation.
Analysts have received the operating cost reductions favourably. JP Morgan analysts – on the BHP tour – called the diversified’s latest plan “impressive”.

But the hard work on costs isn’t translating into stock price bullishness. JP Morgan maintains a neutral stance on BHP shares.

Others rate it higher, though. Cowen and Company gives BHP stock a $67/share target, which at presstime traded just under $58 on the NYSE. That mark, however, was a recent reduction from $74/share.

Reflecting partly the fact that BHP is playing a bit of catch up on costs against front-runner Rio Tinto, analysts hold slightly more positive views of the latter miner. Cowen has called Rio Tinto it’s top pick among diversifieds.

Likewise, JP Morgan prefers Rio Tinto, seeing BHP shares as pricier in terms of free cash flow. Or as JP Morgan put it in a recent note: “we forecast RIO has a more attractive mark to market FCF yield; we forecast BHP’s FCF yield at 4.8{f3b888cd21f4f097cf256c2abf48fb4da5e46c34da410c05974afd2e97e2de2a}/4.9{f3b888cd21f4f097cf256c2abf48fb4da5e46c34da410c05974afd2e97e2de2a} in CY 2015/16E, whilst RIO trades on 5.5{f3b888cd21f4f097cf256c2abf48fb4da5e46c34da410c05974afd2e97e2de2a}/5.8{f3b888cd21f4f097cf256c2abf48fb4da5e46c34da410c05974afd2e97e2de2a} in CY 2015/16E.

There just isn’t enough sweetness in BHP’s cost-cutting plans to get a better rating. It is being aggressive, yes. But not so much as the fall of iron ore prices.

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