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Why the BHP share price could soon outperform

ASX investors fretting over the potential crash in the iron ore price from a trade war induced global economic slowdown will be relieved to hear that the price of the steel making commodity is likely to hold firm for a few years.

That’s the prediction by the analysts at Macquarie Group Ltd (ASX: MQG) even as the broker warned of subdued demand for iron ore.

Our major iron ore producers have lost steam in recent times as China’s economy downshifted a gear or two due to the tariffs the US has slapped on its goods.

This is one of the reasons why BHP Group Ltd (ASX: BHP) share price is lagging with a gain of 6% over the past year – no thanks to a sell-off in its shares over the last two months.

Its peers are doing better though with the Fortescue Metals Group Limited (ASX: FMG) share price surging 125% and the Rio Tinto Limited (ASX: RIO) share price gaining around 16% when the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index is up around 7% over the same period.

A floor in the iron ore price

But BHP’s share price could soon play catch-up following an analyst briefing by the Big Australian’s senior managers.

While Chinese steel demand growth is predicted to slow to around 1% over the next five years as production flatlines, BHP thinks the China’s steel exports will recover.

The miner noted that Chinese domestic iron-ore production has increased from the low point of 189 million tonnes per year (mtpa) to around 220mtpa and that circa 30mtpa additional production will be needed until Brazil’s Vale SA mines return to full output following the tragic Brumadinho dam disaster at the start of the year.

This means the iron ore price will likely be supported around US$70 and US$80 per tonne as that’s the marginal average cost of global production.

Strong margins to support BHP’s share price

That support is some ways below the current iron ore price of around US$93 a tonne, but at least investors will have better visibility of where the floor is. Further, a price of US$70 a tonne will still leave a big profit margin for BHP as it’s one of the world’s lowest cost producers in the world with a unit cost of around US$15 a tonne.

“Steel production in China is expected to plateau over the next five years, and given the supply issues in iron-ore appears supportive of our iron-ore price outlook the next two to three years,” said Macquarie.

“Near-term risk to our earnings forecasts for BHP has emerged due to declines in metallurgical coal, iron-ore and oil prices, however the upside risk to our forecasts for FY21 and beyond remains significant.

“A spot price scenario generates 25% and 35% higher earnings than our base case for FY21 and FY22, respectively.”

Macquarie reiterated its “outperform” recommendation on the stock with a 12-month price target of $40 a share.

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Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited and Rio Tinto Ltd. Connect with him on Twitter @brenlau.

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.