The iron ore spot price is at a record 6-year high of around US$121 per tonne. This has been driven by significant iron ore demand from China and supply issues from iron ore producing countries such as Brazil and India.
China has a massive appetite for the world's industrial metals, and when the country emerged from its COVID-19 woes in March, the government unleashed a flurry of fiscal stimulus aimed at building bridges, roads, utilities, broadband and railroads around the country.
The speed and size at which the country mobilised for economic recovery can only be described as unprecedented, in a good way. In August, its state railway operator announced plans to double its high-speed railway network by 2035. In Guangdong, the city has also put its chips in infrastructure amid slowing growth and plans to spend approximately 700 billion yuan (US$100 billion) this year on public medical facilities, 5G networking and transportation infrastructure. This significant move into infrastructure spending has seen the Chinese economy rebound 4.9% in the July to September quarter.
With iron ore prices holding record highs, let's take a look at what this means for ASX iron ore shares.
BHP Group Ltd (ASX: BHP)
The BHP share price was largely flat during the 3 months ended 30 September. This is in line with the performance of the S&P/ASX 200 Index (ASX: BHP) more broadly, and during a period where iron ore prices had peaked.
As a diversified resources company, BHP derives approximately 64% of its earnings before interest, taxes, depreciation and amortisation (EBITDA) from iron ore, 19% from copper, 9% from metallurgical coal, and 10% from petroleum as per its FY20 results. Iron ore not only generates the most revenues, but also produces the highest EBITDA margins at 70% and the highest return on capital employed (ROCE) at 56%.
In its recent Q1 results, BHP reported iron ore production of 66.04mt, which is a 1% quarter on quarter decline, but is up 7% on the prior corresponding period. Management noted that record quarterly production at Jimblebar and strong supply chain performance offset the impact from planned major car dumper maintenance.
BHP's earnings were relatively flat year-on-year as iron ore prices had spiked in a similar fashion in FY19. Its underlying EBITDA fell 5% to US$22.1 billion while underlying basic earnings per share (EPS) improved by 2% to US$179.2 cents per share. All things considered, BHP delivered a fair result despite 2 cyclones earlier in the year that could have materially lowered production.
Rio Tinto Limited (ASX: RIO)
Similarly, the Rio Tinto share price was also flat during the quarter ended 30 September. The company follows a similar distribution of earning as BHP with approximately 76% of its underlying EBITDA derived from iron ore, 9% from aluminium, 7% from copper and diamonds and 7% from energy and minerals as per 1H20 results.
The 1H20 results highlighted a 12% fall in operating cash flow to US$5.6 billion compared to 1H19, mainly due to lower prices and effect of timing differences. In June 2020, it made a final payment of $1.0 billion in Australian income tax with respect to 2019 profits. Its earnings were marginally weaker due to lower prices for aluminium and copper, while iron ore prices remained stable.
In Rio Tinto's more recent third quarter production results, the company commented that global economic activity in the third quarter was generally strong and helped sustain optimism for a widespread recovery in 2021. However, it also pointed out that recent data suggests that the rate of recovery in growth is slowing in most economies, with pent-up demand dissipating and the rise of renewed lockdowns threatening recovery.
Furthermore, management highlighted that commodity demand in China has been strongly supported by commodity-intensive stimulus measures. However, this is against the backdrop of recovering seaborne supply that was disrupted earlier in the year, with major producers expected to deliver strong volumes in the fourth quarter.
It also noted that steel production ex-China remains down significantly, year on year.
Fortescue Metals Group Limited (ASX: FMG)
The Fortescue share price almost looks like a tech stock, having soared more than 60% this year. However, as a pure iron ore player with some of the lowest production costs in the world, in my view Fortescue could double in share price and still look cheap.
The company's full year FY20 results highlight an outstanding year for shareholders with underlying EBITA increasing 38% to US$8.4 billion, net profit after tax increasing 49% to US$4.7 billion and a fully franked final dividend of A$1.00, lifting total dividends declared in FY20 to A$1.76 per share.
In its Q1 results released this morning, Fortescue reported a strong start to FY21. In the quarter ended 30 September, mining, processing, rail and shipping combined to deliver record first quarter iron ore shipments of 44.3mt, 5% higher than the prior comparable period and 6% lower than Q4 FY2 (this reflected planned seasonal maintenance activity).
Fortescue reported C1 costs of US$12.74/wet metric tonne in Q1 FY21 were 2% lower than the prior comparable period. The miner also confirmed its Eliwana Mine and Rail and Iron Bridge Magnetite projects remain on schedule, with key milestones delivered for both projects in the latest quarter.
Fortescue recorded strong free cash flow generation in the quarter, which contributed to net cash of US$1.0 billion at 30 September 2020, compared to net debt of US$0.3 billion at 30 June 2020.
Foolish takeaway
Rio Tinto's recent commentary could make the case that iron prices have peaked, following surging demand from China and increasing iron ore supply from the rest of the world. This could potentially see some weakness in ASX iron ore shares in the short term, particularly in the Fortescue share price as it only mines iron ore.
However, while iron ore prices may take a breather, China has reiterated its focus on infrastructure and its consumption is likely to remain high to meet its key GDP growth targets.
In my view, the ASX iron ore shares are at a reasonable price level, highly profitable and currently pay market-leading dividends. While I wouldn't classify them as growth shares, I believe their low production costs could make them a consistent ASX 200 dividend option for the long term.
