Rio Tinto [ASX:RIO] has announced plans to increase iron ore shipments to 350 million tonnes in 2016. The decision comes after the mining giant fell 4 million tonnes short of its 340 million tonne guidance for 2015. Should it hit that target, it would see Rio export its full production capacity for the year.
By industry standards, this development isn’t surprising. Slowing demand in China has forced producers into protecting market share. For over a year now, the industry’s been shooting itself in the foot to drive out high cost producers. The lower the cost of iron ore, the harder it is for higher cost producers to stay afloat.
Both Rio and BHP Billiton [ASX:BHP] have played a major role in lifting supply levels. They’ve flooded the market with iron ore because they can afford it better than most. As the two largest iron ore exporters, they have economies of scale. The rest of the market can barely keep up, let alone compete. Yet while they’ve successfully driven prices to as low as US$30 a tonne, the industry remains overcrowded. Most of the major players, including Fortescue [ASX:FMG], remain operational.
Of course, both BHP and Rio can handle iron ore at US$30 better than most. But what’s really helped their cause is their ability to pay out generous dividends.
At last count, Rio was lavishing investors with yields of 7.7%. BHP, too, has one of the most progressive policies on the market, with yields of 11.52%. Either way, both rely on dividends as a way of keeping investors happy and onside. Otherwise, with falling share prices and weak market prospects, neither company would have much going for it at the moment.
Yet there could be changes afoot for both ASX dividend darlings. Ones that threaten to turn investors against both BHP and Rio.
Both companies realise that maintaining existing dividend policies won’t be easy. Not in the long term, anyway. Unless prices recover, it’s hard to see how they could.
But Rio could benefit in the short term if BHP slashes dividends first.
Unlike their competitors, neither Rio nor BHP have been forced into cutting dividends yet. But that could be about to change. A difficult 2015 is placing BHP’s dividend policy under pressure. And it might not be long before BHP has little choice but to lower yields.
BHP or Rio to budge first?
No commodity exporter has benefited from the price routs in iron ore, coal and copper markets. That much is obvious enough to anyone that’s followed the market. But some producers have had it worse than others.
BHP, for instance, has taken hits from several sides. It has major operations in both iron ore and oil. Unlike Rio, which doesn’t sell oil, BHP has watched oil prices slump almost 75% in less than two years.
At the same time, it’s also made some bad calls in expanding into US shale markets. That hasn’t worked out as planned for the company. Shale oil has come under heavy attack from oil interests in the Middle East.
On top of all this, BHP rounded out 2015 mired in the Samarco mine disaster in Brazil, costing the company billions.
At one time, BHP’s diversification looked like an asset. But whatever advantage it had over Rio doesn’t look so promising anymore. If anything, it looks more like a hindrance now that both oil and iron ore are down.
All told, there’s never been more pressure on BHP to lower dividends. Sadly for BHP, and its investors, it may have to revise its policy sooner rather than later. BHP has said it will comment on any decision when it releases financial results in February. Analysts expect it to cut dividends next month at the earliest, or August at the latest.
Either way, BHP faces another tough year ahead. To the point where markets now see Rio as a safer bet than BHP. Not only is Rio a lower cost producer than BHP, but its balance sheet is stronger too.
Analysts expect Rio Tinto will sustain current yields for at least another year. What happens beyond 2016 is less certain though. But it’s unlikely investors are thinking that far ahead just yet. And they probably won’t want to, considering dour forecasts for commodity prices.
There’s no hint of any price recovery. And there might not be for a while yet. Expert forecasts suggest iron ore will remain at current lows for at least another two years. Some analysts even estimate a US$20 floor by 2019. If true, Rio and BHP’s self-defeating market share strategy will have to ease. Otherwise it’s hard to see how either of them can continue paying out such large dividends.
Of course, there’s always an alternative that both could consider. The ASX is no stranger to companies borrowing money to fund dividends. That’s an option that BHP may already be considering. But it would need to borrow enough to match the US$6.5 billion it paid out in dividends last year. And it’s unclear whether the miner would do that in the current environment.
Rio’s dividend obligations are more manageable. With smaller payouts of US$3.7 billion, it’s under less pressure to cut dividends. But this may change depending on future market realities.
As a result, Rio may hold an advantage over BHP for the time being. But it’s a slim advantage, and one that’s not likely to last beyond 2016. Weak growth, low commodity prices, and market oversupply will test Rio’s limits. If BHP isn’t too big to cut dividends, Rio definitely won’t prove the exception.
BHP’s expected dividend cut will complicate what’s likely to be a tough year for mining. BHP could go first, but we shouldn’t expect Rio to be too far behind. If Rio maintains its dividend policy this year, don’t expect it to last too far beyond 2016.
Market update: Rio’s stock opened at $38.69 on Tuesday morning. Its share price is down almost $5 over the past month. BHP, too, has seen its share price slide recently. Australia’s largest miner opened this morning on $14.63. That’s a little under $2 less than it was trading at this time last month. BHP’s share price is down 38% over the past year, compared to Rio’s 27% decline.
Junior Analyst, The Daily Reckoning
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