It hasn’t been the ideal start to 2014 that iron ore investors had been hoping for. The commodity is now trading at just US$98.50 a tonne, down roughly 27% for the year so far, and looking likely to fall even further. In fact, a number of analysts have pegged it to fall as low as US$80 a tonne by 2015!
The volatility shaking the sector is enough to turn me off pure iron ore plays like Fortescue Metals Group Limited (ASX: FMG) and Mount Gibson Iron Limited (ASX: MGX), which are down 24.4% and 28.6% this year respectively. But could there be value from buying one of the industry’s more diversified companies? Let’s take a look.
BHP Billiton Limited (ASX: BHP)
In late 2013, BHP Billiton was highlighted as one of the stocks to buy and hold for 2014. Following on from years of below-par returns, it was thought that the ‘Big Australian’ would take over from the banks as the stock to lead the market to new heights. Thus far, that has not been the case with the stock down 1.5% compared to the S&P/ASX 200’s (Index: ^AXJO) (ASX: XJO) 1.2% rise.
BHP Billiton’s high level of diversification makes it a safer bet than others in the industry. While iron ore remains its primary generator of revenue, it also maintains a strong focus on copper, coal and petroleum, as well as potash. Thus, any drop in price for iron ore wouldn’t have as big of an impact on earnings or its share price as it would for other companies.
The miner is currently on target to produce 217 million tonnes of iron ore for the year, compared to 170 million tonnes in 2013. The increased production as well as cost-cutting initiatives could see BHP Billiton announce an annual profit just short of its record US$15.4 billion profit recorded in 2008.
Rio Tinto Limited (ASX: RIO)
Rio Tinto also maintains diversified operations, albeit not to the same extent as BHP. The miner last week announced that its operations in the Pilbara were now producing 290 million tonnes per year, while they are aiming to produce around 360 million tonnes by 2018.
Given its far greater production rate than BHP Billiton, Rio Tinto maintains a lower breakeven price. Some estimates suggest that Rio Tinto breaks even at US$44 a tonne, meaning that it will still remain profitable even as iron ore continues to fall in price.
The problem is, iron ore accounts for more than 90% of Rio Tinto’s overall earnings. Although its increased supplies will counteract some of the impact from the price fall, Rio’s earnings will still come under pressure. The market has recognised this and has sold shares down by 12.5% since the beginning of the year.
Of Australia’s two largest iron ore miners, BHP Billiton is by far the better bet even though it trades on a higher P/E ratio (13.4 compared to 8.5). Regardless, investors should only put their money behind the stock if they are prepared for volatility and willing to ride it out over the long-term.
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Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned.
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