With oversupplied commodity markets, 2016 looks set to be another tough year for mining sector. But here are three compelling reasons to be bullish with two of the best-placed miners:Â Rio Tinto (LSE: RIO) and BHP Billion (LSE: BLT).
1. Cost leadership
Competitive strength is one of the most important factors to look out for when making long term investment decisions. With little product differentiation in the natural resource sector, mining companies can only achieve competitive strength through one strategy – cost leadership.
Precisely because of this, Rio and BHP are market leaders for a wide range of commodities, including iron ore, copper, coal and bauxite. Thanks to a focus on massive projects, these two firms benefit from economies of scale and high levels of productivity. Their production costs are at the very low-end of the cost curve for most commodities.
This gives them a competitive advantage over their rivals and enables them to generate wider margins and excess returns throughout the cycle. Rio enjoyed an adjusted EBITDA margin of 34% in 2015, while BHP’s margin was 40%. This compares very favourably to Glencore and Anglo American, which have adjusted margins of 16% and 21%, respectively.
2. Expanding production
An increase in production may be the last thing that the sector needs right now, but when you have one of the lowest production costs in the industry, expansion leads to greater profitability even though it puts further downward pressure on market prices. Furthermore, lower commodity prices in the meantime may actually help low cost producers in the long term. Lower prices should push out the more expensive producers, which reduces supply in the market and lends support to higher prices in the longer term.
Although the market is currently massively oversupplied, some commodities may actually transition to a supply deficit by the end of the decade. Many analysts still have positive long term views on base metals, particularly copper and nickel, because large-scale mines for these commodities are ageing. This causes productivity from these mines to fall, and potentially could cause global supply to decrease.
There is a scarcity of large projects coming onto the market over the next several years, and BHP and Rio are the few miners with big development projects. Rio is particularly attractive, because it has better upside production potential coming from its mega projects, Oyu Tolgoi and Pilbara, which produce two of its most profitable commodities – copper and iron ore.
3. Strong balance sheets
BHP and Rio may have recently cut their dividends, but their balance sheets remain robust. With net gearing below 30%, they are both in a unique position to benefit from mergers and acquisitions (M&A). This is a huge potential positive because today’s low asset prices and the lack of bidding competition makes it a buyer’s market. M&A could bring greater scale and bargaining power, which could further improve their competitive advantage in the long run.
Although both companies will still face some short-term obstacles, their strong balance sheets gives us confidence that both companies are well-placed to cope with lower prices for longer. It’s near impossible to time the bottom of the market, but at least we can be confident that BHP and Rio have the financial flexibility to ride out the commodities supercycle.