MANDA SAUNDERS

Gap likely to stay Just started Aberdeen is one of BHP's biggest shareholders. Increased ferocity Come down faster Both miners are running rapid expansion programs in iron ore. They have copped criticism for flooding the market with new supply, which is weighing heavily on prices. Leading charge

BHP Billiton has narrowed the gap on production costs with the world's lowest-cost exporter of iron ore, Rio Tinto, but is unlikely to be able to close it completely.

The two miners are in a fierce race to hammer their costs down even further, as BHP chief Andrew Mackenzie warned last week that depressed iron ore prices were here to stay. While much of the junior iron ore sector is on its knees, the two majors could pare production costs to less than $US15 a tonne within 18 months, tightening the screws further on their struggling competition. Iron ore prices have collapsed about 50 per cent in the past year to sit at about $US63 a tonne. In October, BHP threw down a challenge that it could claim Rio Tinto's coveted mantle as the world's lowest-cost exporter of iron ore to China within three years. And Mr Mackenzie stressed last week that BHP had an "extreme imperative" to continue to drive costs down and become the world's lowest-cost exporter of iron ore to China. But it is a tall order. BHP has made astonishingly quick work of paring the gap between its cash costs and those of Rio from about $US8 to $US9 a tonne last year to current levels of $US3 to $US4 a tonne.

Gap likely to stay

That gap was likely to stay at $US3 to $US4 a tonne, Deutsche Bank mining analyst Paul Young said. "Rio will keep ahead. There are still structural differences between the two businesses where Rio has the upper hand," Mr Young said. "On the cost line, Rio has more upside on profitability through economies of scale and automation, and their ports are cheaper." The two miners are neck and neck on most key costs of production metrics, with the key differential on cash costs. Cash costs cover mining, processing and administration but exclude royalties, exploration costs, sustaining capital and depreciation and amortisation, along with interest and taxes. BHP slashed iron ore cash costs by 29 per cent in the six months to December to $US20.40 a tonne. Rio also made rapid progress in the period, cutting cash costs to less than $US17 a tonne.

Just started

Rio had only just started to get aggressive on making iron ore cost cuts, whereas "BHP has taken out a bigger knife, and been more dramatically more recently on it", Mr Young said. "Rio has been investing for the longer term on cost cuts," he said. "It is about five years ahead of BHP on automation and has been relying on capital efficiency for a longer time than BHP." BHP has made deep cuts quickly, targeting maintenance and contractor rates, as well as procurement, and is well ahead of its costs target. Just five months ago, BHP iron ore boss Jimmy Wilson outlined a three-year plan for the iron ore business, saying BHP could shave 25 per cent off cash costs to less than $US20 a tonne by 2017. Michelle Lopez, senior investment manager at Aberdeen Asset Management, said BHP's rapid progress on iron ore costs was "a huge achievement". "It's not at the expense of capex, it is a tightening down on contractors and being more efficient, among other things. That's a very good outcome."

Aberdeen is one of BHP's biggest shareholders.

Increased ferocity

But now Rio has increased the ferocity of its cost drive, with iron ore chief executive Andrew Harding sending a memo to staff last month warning of a "degree of urgency" to quickly achieve deep cost cuts and maintain its mantle as the lowest-cost producer in the Pilbara. He put an immediate hiring freeze on all staff and started a "review of organisational structures". His memo to staff detailed how aggressive cost cuts would be executed across the division. "The scenario for 2015 and beyond reinforces the absolute need for us to maintain our position as the lowest-cost producer, particularly when compared with other Pilbara producers," Mr Harding wrote in the note. "To maintain favourable cash cost earnings, we must substantially and quickly decrease our operating costs. We also cannot let go of tonnes, both new and incremental." Rio's all-important breakeven price – at which it is not making or losing cash – is about $US37 a tonne, while BHP's is understood to be about $US40 a tonne. Cash costs are the key component that the miners can control. Key uncontrollable factors – the oil price and Australian dollar – have been a boon for both miners. And the two majors could take costs to less than $US15 a tonne within the next 18 months, if the oil price stayed at current levels and the Australian dollar dropped further, Mr Young said.

Come down faster

"Uncontrollable costs have come down a lot faster than everyone thought. On top of that your general controllable costs are coming down much faster too, which comes down to productivity per person and contractors, maintenance," he said.

Both miners are running rapid expansion programs in iron ore. They have copped criticism for flooding the market with new supply, which is weighing heavily on prices.

Rio is on track to hit 330 million tonnes of production this year and 350 million tonnes by 2017, and produced 295 million tonnes last year. BHP has a smaller production base to spread costs over – it is set to produce about 250 million tonnes this year, and is targeting 290 million by 2017. Rio's mining costs are ultimately cheaper than BHP's. In addition, Rio had better blending capabilities and would therefore always get a better realised price than BHP, Mr Young said. Lower prices were here to stay for a while, BHP said. The miner said on Tuesday that in the last half, "as the marginal cost of supply fell, the iron ore spot price also declined to levels [that] are now more reflective of the medium-term fundamentals". Mr Mackenzie warned last week that depressed iron ore prices were here to stay, after BHP recorded a 31 per cent decline in underlying profit for the six months to December of $US5.3 billion. The result beat analyst expectations.

Leading charge

"I think we are leading the charge (on cost cutting), but it's certainly true that ... nobody is remaining static in what's possible," Mr Mackenzie said. The looming wall of seaborne supply was "almost certainly going to push iron ore (prices) to the low side for a while", he said. "Over the medium term, as new seaborne supply continues to exceed growth in demand, we expect iron ore prices to remain subdued. "Longer term, the increased availability of scrap steel in China will impact pig iron demand and therefore for iron ore." The predicted rise of the scrap metal market next decade in China "makes the cost imperative in iron ore and our determination to be the lowest-cost supplier to China absolutely critical to continue the track record we're talking about today", he said. Brad Potter, head of Australian equities at Nikko Asset Management, said the flood of new supply could lead to further price falls. "There are negative implications, arguably, on valuation, given that the cost curve will continue to flatten, resulting in lower long-term prices. "They are making good moves on the cost side, but this just softens the blow from falling revenues." BHP is the second-biggest underweight position for Nikko Asset Management's $1.38 billion Australian shares fund.