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BHP or Rio: Who’s got the best iron ore strategy?

In investing, there are no certainties. For example, share prices will rise and fall without reason (although every financial pundit will find one), commodity prices will continue to defy forecasts and company profits will beat expectations.

However, if history has taught us anything, those who are observant and conscientiously making objective sacrifices today for what they believe will be an opportunity in the future, are more likely to be rewarded than those that don’t. The problem is that making such decisions comes with risk.

That’s why teams of analysts will scour over annual reports, quarterly production figures and government data to build their own model of the future. Even our country’s biggest companies, such as BHP (ASX: BHP) and Rio Tinto (ASX: RIO), are seemingly at odds over the future, particularly Chinese demand for iron ore.

Although both appear to want to increase their production targets by investing billions of dollars in infrastructure, bigger might not be better — particularly given the pooling debts and downside risks if they get it wrong.

BHP has now realised how difficult it can be to predict Chinese demand (and subsequently the price of iron ore) and its US$20 billion Port Hedland outer harbour project is at a standstill. Despite recently announcing it’ll meet an annual production target of 212 million tonnes of iron ore in 2013-14, the increases will come from its existing Jimblebar site in a bid to “squeeze out as much as possible” – according to The Wall Street Journal.

BHP’s marketing president, Mike Henry, said the diversified miner is likely to reduce its dependence on iron ore in years ahead: “We expect a transition away from the traditional steel-based commodities over the long run.”

Meanwhile Rio has upgraded ports and infrastructure to meet an almost certain increase in production in the next five years that will capitalise on increasing Chinese demand. A production expansion could see the mining giant increase its annual capacity to 360 million tonnes, but will cost US$5 billion.

The real risk for Rio is if the spot price of iron ore falls quicker than anticipated. The Bureau of Resource and Energy Economics recently published a report that forecasted iron ore prices to average US$91 per tonne in 2018. Currently iron ore sells at over US$135 per tonne. Although Rio will still be profitable at 2018 levels, it would make an investment case in the almost ‘pure play’ iron ore behemoth hard to justify.

Foolish takeaway

If you wanted exposure to iron ore and mining, BHP is a safer bet because it has much more diversified revenues, including copper, potash and petroleum. Rio Tinto, on the other hand, although perhaps a greater beneficiary of an iron ore boom, is less diversified and doesn’t have the ability to draw revenue or invest in other areas – especially while shareholders and senior management are pushing to keep costs down. Neil Gregson, a fund manager for J.P. Morgan Asset Management summed up Rio’s predicament quite well when he said, “If Rio were to move away from iron ore, where does it go?”

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Motley Fool contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies

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