BHP or Rio Tinto: Which iron ore strategy should you bet on?

Rio Tinto’s plan may have greater upside, but it comes with more risk.

In recent months, many financial commentators have been making bold forecasts for the S&P/ASX200 (ASX: XJO) (^AXJO) index for the year ahead. Some have even predicted ASX 6000!

Whilst ASX 6000 seems feasible, it will require a strong rally by some of the biggest resources companies such as BHP Billiton (ASX: BHP), Rio Tinto (ASX: RIO), Woodside Petroleum (ASX: WPL), Fortescue Metals Group (ASX: FMG) and Santos (ASX: STO). Santos and Fortescue were the only two which outperformed the index in 2013.

BHP and Rio have a huge weighting on the index – some 11.3% combined – but are yet to have any meaningful rallies. One reason for their underperformance has been investors’ disconnect with anything iron ore.

In 2013, many analysts had predicted a significant fall in iron ore prices because of massive production increases coming online just as the Chinese economy was expected to halt. Although we witnessed a rebound in their share prices for the second-half of the year, many analysts are still forecasting lower iron ore prices in 2014. For example, investment bank UBS are estimating prices will average less than US$100 per tonne – down from US$134 currently.

Perhaps counter-intuitively in the past 12 months, both BHP and Rio have committed to increasing iron ore production – Rio plans to produce a whopping 360 million tonnes of iron ore per annum from its Pilbara operations by 2017. As Rio derives over 80% of earnings from iron ore, the expansion made sense, especially given its ability as a very low-cost producer.

The Pilbara mines are renowned for their high quality and low-costs of production. Fortescue, BHP and Rio each produce the steel-making ingredient for less than US$60 per tonne. According to Rio it can dig up, freight, and ship its iron ore from Pilbara mines for less than US$50 per tonne. Therefore, even if long-term prices do fall below US$100 per tonne they’ll still be making a profit – just less of it.

Despite Rio’s reliance and bullishness on iron ore markets, BHP has taken a more conservative approach. Although it too is ramping up production, it recently warned that iron ore markets in China could dampen, as the economy transitions from an investment-led economy to a consumption-led one – according to The Wall Street Journal. This will likely boost prices of other hard and soft commodities like copper, petroleum, gas, fertiliser, grains and meat.

A fallout in iron ore prices doesn’t paint a pretty picture for miners like Rio and Fortescue (especially when they have such high levels of debt) but there is hope that other Asian economies will pick up the Chinese slack.

Foolish takeaway

At current prices, BHP is a more conservative but still a rewarding company for exposure to the iron ore industry. In addition its potash, petroleum and copper businesses have great long-term potential, which will see continued demand from the Chinese economy for many years to come. Rio’s reliance on iron ore and China makes it a riskier alternative but, if it stays high, it could be an extremely rewarding investment.

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Motley Fool Contributor Owen Raskiewicz does not have a financial interest in any of the mentioned companies.  

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