3 major threats to BHP Billiton Limited and Rio Tinto Limited

Which company would you pick?

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If you picked falling iron ore prices as one major threat to both BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO), you’d be right.

But the other two threats could have fairly negative impacts on their profits for years to come.

With both companies at the beck and call of commodity prices, you’d also be right that the other two big threats to their earnings are prices of two commodities in particular.

Copper plays a major role in revenues for both BHP and RIO, bringing in US$7.1 billion for BHP in the last half-yearly results, and US$5.9 billion for RIO in 2013. But copper prices have been sliding due to a global oversupply, and reportedly, millions of tonnes stockpiled in China. Prices have dropped below US$3/lb since the beginning of this month, and analysts are predicting further falls.

With copper viewed as a bellwether commodity, fears are rising that other commodity classes could be in danger of price contagion, adding another element of danger for BHP & RIO.

The other commodity that has been sliding for some time now is coal – both thermal and coking (or metallurgical) coal. Coking coal is used in steelmaking, while thermal is used to produce energy.

Thermal coal prices peaked at US$136 a tonne in March 2012, and it’s been downhill ever since, currently changing hands for around US80 a tonne. Coking coal on the other hand, has been smashed since peaking around US$330 a tonne in 2011 – it’s now near the lowest levels in seven years at around US$140 a tonne — and is still falling.

BHP generates around 73% of earnings before interest and tax (EBIT) from iron ore, copper and coal, while RIO has a whopping 96% of its net profit (NPAT) generated by iron ore, copper, coal and uranium.

The combined effect of falling iron ore, copper and coal prices would be devastating to both major miners, and profits could evaporate in the blink of an eye, especially for RIO with its much greater reliance on the three commodities.

Recent moves by pure play iron ore miner Fortescue Metals Group (ASX: FMG) to pay down as much debt as it can, as fast as it can, despite incurring some penalties to do so, show where the company thinks iron ore prices are headed, which could be trouble for higher-cost junior miners Arrium Limited (ASX: ARI) and Mount Gibson Iron Limited (ASX: MGX).

Foolish takeaway

If you absolutely must have exposure to resources, Rio Tinto is not the diversified play you’d want in your portfolio. BHP, with its greater diversity, offers at least some downside protection should we see iron ore, copper and coal prices slump further (which appears likely).

Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

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