Why I’d buy BHP Billiton ahead of Rio Tinto

With iron ore prices continuing their slide, BHP looks a better bet than Rio

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Overnight, iron ore prices fell below US$120 a tonne, to U$117.80 a tonne, continuing the recent slide. Two weeks ago, iron ore officially entered bear market territory, after falling more than 20% from its high of US$158.90 a tonne in February 2013. At that stage, prices were around US$125 a tonne.

For Australia’s big miners BHP Billiton (ASX:BHP) and Rio Tinto Limited (ASX:RIO), which both generate a significant proportion of earnings from iron ore, it’s not good news. However, both BHP and Rio are amongst the lowest cost producers of iron ore, with total costs of between US$40 – US$50 a tonne. At current prices, both miners are still generating significant profit margins on iron ore, and would still be profitable at much lower prices. Although, that may not be the case for smaller iron ore plays like Mount Gibson Iron (ASX:MGX) and even Fortescue Metals Group (ASX: FMG).

Based on the latest earnings reports, Rio generated 91% of its net production earnings from iron ore, with another 11% coming from copper, 3% from coal and uranium and 1% from diamonds and minerals. Other operations generated a loss representing -5% of net production earnings. With Rio ramping up its iron ore production, iron ore will become an increasingly larger part of company earnings and it’s virtually a pure iron ore play.

By contrast, BHP’s iron ore earnings before interest and tax (EBIT) represents 49% of total EBIT. Petroleum contributed 32% of EBIT, with copper another 20%, while coal, nickel, aluminium and other commodities making up the minor difference. While BHP is also in the process of ramping up its iron ore operations, the company is significantly increasing its petroleum production, with just its Eagle Ford shale increasing output five-fold over the next four years. Total petroleum production is expected to be 50% above current levels by 2017.

Foolish takeaway

Iron ore prices are expected to fall further, as China moves away from an industrial focused economy to a consumer-based economy. Other emerging nations are unlikely to fill in the fall in demand. While the falls in the Australian dollar will offset some of the falls in commodity prices, it won’t totally compensate the miners. Rio and BHP will also offset some of the fall in commodity prices by increasing production volumes, but Rio’s profits are more likely to fall faster and further than BHP’s, thanks to its almost total reliance on iron ore. If you think the miner’s might be cheap, BHP looks a better bet than Rio.

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Motley Fool writer/analyst Mike King owns shares in BHP.

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