The Best Way to Play Rising Iron Ore Prices

Iron ore prices have recently been on the up, pushing as high as $137 per ton thanks to heavy Chinese buying. This recent rally took the price from $114 to $137 in just under two months as Chinese steel producers replenished their inventories after two quarters of de-stocking.

In addition, a wave of construction activity is currently sweeping across the country, dragging China's manufacturing purchasing managers index, a key measure of industrial activity within the country, to a six-month high in September, according to HSBC.

That said, the price of iron ore has ticked down slightly during the past month as traders place bets on China's steel production slowing slightly during the fourth quarter. Still, China is expected to produce 770 million tons of steel this year, a record for the country.

China is also making moves to exert more control over the iron ore market with the creation of the worlds first physically delivered iron ore futures contract. This contract began trading on the Dalian Commodity Exchange during October. Not only will this give China more power over price and supply of the commodity, it will also allow commodity giants such as Cliffs Natural Resources , Vale , and BHP Billiton to establish better control over their own iron ore production.

But at what cost?
Rising iron ore prices and more control over the price at which iron ore is sold to customers is all good news for investors that have holdings within iron ore miners, such as those listed above.

One of my favorite ways to evaluate mining companies is to work out their production costs per ton. This is extremely helpful when trying to establish how profitable a company will be in the future. For example, one of my favorite miners, listed in the UK, is Ukrainian based Ferrexpo. Ferrexpo mines iron ore at a cost per ton of just under $60, which makes the company extremely cash generative and profitable. 

Of course working the cost per ton figure out for Cliffs, Vale and BHP Billiton will not be totally indicative of how good their results will be. These mining behemoths are well diversified and produce many commodities, so a rally in iron ore prices will not necessarily mean a good quarter. That said, all three companies get the majority of their income from iron ore production, so some knowledge is always helpful.

Crunching numbers
Firstly, let's take a look at BHP Billiton. The company produced 170 million tonnes of iron ore during fiscal 2013. This 170 million tonnes of iron ore generated revenue of $20.2 billion, or 31% of total revenue, indicating that the company sold its iron ore production for an average price of $118.90 per tonne. All in all, on revenues of $20.2 billion the company produced earnings before interest and tax, or EBIT, of $11.1 billion, indicating a cash production cost per tonne of $65.90.

As BHP reports in the UK, the company uses the metric long tonne. One long tonne is worth approximately 1.1 short tons, indicating that BHP's production cost per short ton is around $60.

Meanwhile, Vale produced 320 million tons of iron ore during 2012, from which it generated $27.2 billion, 56% of total revenue. This indicates that the company sold its production for around $85 per ton, significantly lower than BHP. That said, we should keep in mind that the iron ore price was, on average much lower during 2012 than the first half of this year. Although Vale does not give detailed income figures on a divisional basis like BHP, Vale's annual report does show that the operating margin on ores produced was 49%. As iron ore accounted for 65% of the company's ores produced during 2012, we can assume that Vale's production cost per ton of iron ore produced was around $41.70 during 2012.

Cliffs is by far the mostly shareholder-friendly company in this group. The company helpfully sets out all of its cost and revenue figures in a handy table right at the top of its earnings release. In particular, during the first nine months of this year the company's cash cost per ton was $64.91, up slightly from 2012's figure of $64.48. What's more, Cliffs also gives us a depreciation, depletion, and amortization figure per ton, which takes the total cost per ton to $70.36. Overall, this does show us that Cliffs is the most inefficient company of the three. However, the shareholder communication is the best, and that is worth noting.

Foolish summary
With the price of iron ore rallying hard off the back of strong Chinese buying, it is helpful to know which companies are best positioned to benefit. With an estimated production cost of $60 per ton, BHP is by far the most efficient iron ore producer, and the company should be in line for a strong rise in profitability throughout the rest of this year.

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Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. 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.

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