May 5, 2016 / 6:42 AM / 2 years ago

COLUMN-Rio, BHP investors may be too cautious on iron ore rally: Russell

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Clyde Russell

LAUNCESTON, Australia, May 5 (Reuters) - If you are looking for signs that the China-led surge in iron ore and steel prices is likely to fizzle, the fact that the share prices of producers are lagging miles behind is a strong indicator that the commodity rally may be shaky.

Spot iron ore for delivery to China .IO62-CNI=SI has surged almost 43 percent this year, closing on Wednesday at $61 a tonne. Those gains looked more impressive two weeks ago when prices hit $68.70, its highest since January last year.

In contrast, Rio Tinto, the Anglo-Australian miner that derives some 90 percent of its profits from the steel-making ingredient, is up just 7 percent this year in Australian dollar terms, and 9.5 percent in U.S. dollars.

Fellow major producer BHP Billiton, has gained 5.2 percent in Australian dollars and 7.8 percent in U.S. currency.

While top producer, Brazil’s Vale, has done significantly better, gaining 35 percent in the local real since the start of the year, and 50 percent in greenbacks.

It’s worth noting that iron ore, despite its surge so far this year, is still 68 percent below its all-time high above $190 a tonne, reached in February 2011.

Both Rio Tinto and BHP didn’t fall quite as dramatically from the record iron ore price, having respectively declined 45 percent and 55.5 percent in Australian dollars and 60 percent and 67 percent in U.S dollars since then.

Vale is down 83 percent in U.S. currency terms since February 2011, showing its outperformance over Rio and BHP so far this year comes against a backdrop of considerable underperformance in the past five years.

Rio Tinto has seen a strong correlation in recent years to the iron ore price, so the relative lack of improvement in its share price, especially when compared to the robust gains in iron ore, most likely shows intense scepticism on the part of equity investors.

Of course, share prices are also subject to other influences, such as general market sentiment, which hasn’t been positive in recent weeks, and news developments.

BHP has also been buffeted by a $44 billion claim launched against it and Vale relating to the fatal collapse of a dam at their jointly-owned Samarco mine in Brazil.

While the final settlement is expected to be considerably less than the initial claim, the prospect of a major liability will likely dog BHP until the matter is resolved.


But the question still remains as to whether equity investors haven’t taken enough notice of the gains in commodity prices and the likely impact on resource company profits.

BHP’s half-year results presentation on Feb. 23 stated that the company’s net profit after tax changes by $147 million for every $1 per tonne movement in the iron ore price.

At that time, most analysts were more focused on what that would mean from a negative perspective, given expectations of declining iron ore prices at the time.

But the spot iron ore price averaged $53.20 a tonne in the first quarter, up from $42.90 in the fourth quarter of last year, and it may continue to rise in the current quarter given it has spent much of the period so far above $60.

Using BHP’s own numbers, the gain in profits for just the January-March period should be $1.514 billion, significant when compared to the $6 billion in earnings before interest, depreciation, tax and amortisation reported for the half year ended December 2015.

Put another way, another quarter of iron ore prices around $60 a tonne will result in an almost 50 percent boost to BHP’s profits, assuming all other factors remain unchanged.

The stronger iron ore price will probably have a bigger impact on Rio’s bottom line as it produces more than BHP does, mining some 84 million tonnes in the first quarter of 2016.

While there are some reasons to be cautious about the extent of the rally in iron ore and steel prices in China, there is some fundamental basis for the moves, given measures to boost infrastructure and construction, two of the main consumers of steel.

There is also little doubt that futures prices on China’s commodity exchanges got ahead of themselves, prompting last week’s moves to calm markets by increasing capital ratios and transaction costs.

But if price gains can consolidate around current levels, or even slightly lower, the revenues enjoyed by companies like iron ore’s big three will jump in coming quarters.

Disclosure: At the time of publication Clyde Russell owned shares in BHP Billiton and Rio Tinto as an investor in a fund.

Editing by Himani Sarkar

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