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Will falling iron ore prices hurt BHP and Rio?

Spot iron ore dropped US$2.30 this week to US$120.90, which is close to the recent lows set in December 2012 but still up on the sub-US$100 lows reached in September 2012. Given the diversified nature of BHP Billiton’s (ASX: BHP) and Rio Tinto’s (ASX: RIO) assets and the lower cost positioning of their iron ore assets, shareholders of BHP and Rio are more protected from further falls than shareholders in the ‘pure play’ iron ore miners.

The iron ore price does however still play a big role in future earnings growth or earnings pressure of BHP and Rio. The iron ore operations of these two giants have contributed massive windfall profits to their bottom lines. For example, BHP’s earnings before interest and tax margin on iron ore has been running at over 50% since about 2005, as such these windfall profits are not easily replaced. While a falling Australian dollar (AUD) does soften the blow from falling iron ore price, on BHP’s numbers the AUD needs to fall by one cent for every one dollar fall in ore prices.

BRW Rich list member Andrew Forrest and his company Fortescue Metals (ASX: FMG) will be watching the price action even more closely given his company’s sole exposure to iron ore. The same can be said for Atlas Iron (ASX: AGO) and Mount Gibson Iron (ASX: MGX). Unsurprisingly, Fortescue, Atlas and Mount Gibson have all lagged behind BHP, RIO and the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) since September last year.

chartBHP

Source: Google Finance

Foolish takeaway

While the chart above shows recent underperformance, the last five years show an even bleaker return. While investors might think there is now value in the sector, Foolish investors should take an even longer-term view and consider just how long a full resource cycle can take to play out.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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