Okay, let’s set this thing up. Less than a decade ago, China’s economy was growing at 10+%. Now, it’s more like 7 or 7.5%. It’s no coincidence then that between 2010 and 2012, the price of iron ore reached highs of between $160-$180/tonne. Now, however, it’s trading around US$70/tonne.
Last year iron ore miner Rio Tinto (LSE: RIO) (NYSE: RIO.US) pumped out a record 251 million tonnes of iron ore. The miner’s still trying to capitalise on the relatively strong demand today. Rio says it’s currently working on creating capacity for 360 million tonnes per annum. This is happening at the same time as obvious price signals from the market suggest that the heyday for iron ore is actually over.
The other ‘naughty’ commodity is crude oil. Over the weekend Brent crude slipped under US$70/barrel. The price hasn’t been that low for around four years. Many price forecasts at this point are just stabs in the dark but some analysts are now calling a drop to US$60/barrel. Despite oil falling into a bear market, OPEC has indicated it won’t take any action to reduce supply (currently around 30 million barrels a day).
BP (LSE: BP) (NYSE: BP.US) shareholders have been more than a little frazzled by these developments. Last Friday, the stock price fell 5%.
What’s going on?
To state the obvious, global demand just isn’t there to soak up the level of supply that’s currently being generated in both the oil and iron ore markets. With regard to iron ore, it’s largely a China story. The nation imports two thirds of the 1.2 billion tonnes of iron ore traded annually. In terms of oil, it’s a US story. Analysts estimate that the US has cut its oil imports by 8.77 million barrels per day since 2006. The world’s largest economy is ever so gradually moving towards tapping its shale resources for energy production. Experts, though, say that squeezing shale oil out of the ground becomes economically unviable when crude oil approaches $60/barrel. It seems OPEC knows this and is prepared to take a bullet to the arm (cop lower oil prices in the short term) rather than a bullet to the heart (by shale gaining more market share).
What does it mean for Rio and BP investors?
City analysts estimate that for every $10 or £6 per tonne drop in the price of iron ore, Rio Tinto’s annual revenues fall by $2.8 billion. So if the price falls further, investors could see as much as $7 billion knocked off Rio’s bottom in the medium to long term. In fact, analysts at Citigroup estimate that by as early as 2018 the iron-ore surplus will exceed 300 million tonnes. That has the potential to send the price into the $50/tonne area.
BP faces a similar story. The oil producer says it loses about $275 million in annual pre-tax operating profit when the price of Brent crude drops $1/barrel. However, and that’s a big “however”, its refining business (helped by the lower cost of oil) provides a cushion for its bottom line to the tune of around $500 million in additional operating profit annually.
The “so what” section
The share prices of Rio Tinto and BP will be under pressure until the markets for both iron ore and oil stabilise. BP has the benefit of being an oil refiner, and having OPEC to manage long-term supply problems in the market. Rio Tinto, on the other hand, may not see a return to those high iron ore prices for some time, if ever. In response, the miner is ramping up production as we speak to make up for the fall in prices — counter-intuitive? …yes, but the company is desperate to maintain shareholder value and believes higher volumes at lower costs will help margins. If this continues the supply glut will only grow larger and the share price will fall, as will the dividend.
If you insist in gaining exposure to the resources sector and mining companies, please please please chase the diversified miners with more than just one major market. I’d be most grateful. There’s too much volatility in the market at present to have all your eggs in one basket.