Why BHP’s iron ore strategy is still intact

Even in the face of lower iron ore prices, BHP Billiton (BHP), Rio Tinto (RIO), and Vale SA (VALE) are maintaining their production targets and planned capacity increases.  BHP announced that it plans to expand its iron ore capacity from the current 250 million tons to 290 million tons by 2017. The company intends to raise its capacity by making its existing operations more efficient—not by building any new mines. This will help decrease unit costs.

Big miners are hoping that increased low-cost volumes flooding the seaborne iron ore market will drive out the high-cost marginal players. This strategy will take time to play out for several reasons, including sticky supply in China due to government protection and captive mines.

In the meantime, margins should narrow. To some extent, falling costs and depreciating local currencies could contribute to this. Higher-cost players like Cliffs Natural Resources (CLF), on the other hand, are facing increasing pressure due to rising supply and shrinking prices.

To learn more about the reasons for supply stickiness, read Plumbing new lows: Key iron ore indicators to watch.

Now, BHP expects a unit cost of $20 per ton of iron ore, excluding royalties and freight. If the company is able to reach this unit cost level, it will become the lowest-cost supplier to China. Rio Tinto, the lowest-cost producer, currently has a cash cost of $20.40 per ton, excluding freight and royalties.

Focusing on productivity will lead to volume growth from existing mines. Jimblebar Phase I will achieve 45 mtpa (million tons per annum) on a 100% basis. Mining Area C volumes and Newman will increase by 8 mtpa and 10 mtpa, respectively.

Volume growth and lower unit costs should help BHP in this weak iron ore price environment. The company should also get some support from weaker local currencies. However, lower prices are definitely putting a strain on the company’s cash resources. BHP isn’t able to reach a comfortable net debt position so that the company can start capital to the shareholders.

Investors who are interested in diversified exposure to this sector should consider the SPDR S&P Metals & Mining ETF (XME).