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Although China's economic growth is slowing, the country's demand of steel and iron is still increasing due to urbanization. In 2014, steel production is expected to grow by 3.1% over last year. Because of increasing steel output, China's iron ore import is expected to grow by 50 million metric tons this year, a rise of about 6% year over year. As the country buys about 65% of global iron ore production, it will boost sales from global iron ore miners.

One concern that could hamper China's steel production, is the country's initiatives to cut air pollution, which is caused by industrial activities. Last year, hazardous smog was seen in the country's many large cities, so China has asked steel producers to reduce emissions, which cause air pollution. To reduce air pollution, about 15 million metric tons of steel capacity is expected to be cut this year.

Though the steel supply cut will reduce demand of low-grade iron ore, consumption of higher quality iron ore will increase. Higher-quality iron ores are not required to pass through the pre-treatment step of sintering, which is a major cause of air pollution. Shifting to higher-quality iron ore will cut exports from countries such as Iran, Mexico, and Vietnam, as their iron ore contains higher sulfur content, which generates more pollutants when it is removed during processing. Iron ore from these countries contains 1.5%-2% of sulfur.

Consequently, the reduction in exports from these countries will help high-quality iron ore miners such as BHP Billiton (BHP), Vale SA (VALE), and Rio Tinto (RIO), because sulfur content in their iron ore is just 0.05%. These companies already account for 59% of the global iron ore trade, and with decreasing demand of low-grade iron ore, their export volumes are expected to increase further.

BHP is optimally allocating its production

With the potential demand of higher-grade iron ore in China, BHP has started selling blended iron ore lumps. The iron content in the ore at two of its mines -- Newman mine and Mining Area C (MAC) -- is 63.6% and 62.4%, respectively. By blending these two quality ores, the company is manufacturing a single product with 63.2% iron content. As customers prefer iron ore with higher iron content, there is more demand for BHP's Newman lump, and less for MAC lumps, which have lower iron content. Thus, blending two qualities allows the company to produce lumps with higher iron content. Doing so, the company will be able to sell higher volumes of MAC iron ore, than selling it as separate product.

In addition, because of higher iron content the company is selling blend lumps at a premium. From December 25 to January 3, the company shipped about 70,000 metric tons (MT) of blend lumps to China, at a premium of $0.315 per dry metric ton over Platts 62% Iron Ore Index -- the price index used in North China for iron ore with 62% iron content. With increasing demand and a higher price for its higher-quality iron ore lumps, I expect BHP's sales will improve this year.

Focus on returning more value to investors

In the 2013 financial year, which ended in June, BHP spent about $21.7 billion on 16 projects. These projects included the Jimblebar mine in Australia's Pilbara region, which was started to meet growing iron ore demand in China. The company is planning to increase the annual production capacity of the mine, to 35 million metric tons, by the end of 2015. Iron ore from the Jimblebar mine is high quality, containing about 62.7% iron content. With this mine, the company's annual iron ore production capacity will increase to 220 million metric tons. The additional capacity will enable the company to meet the demand in China for higher-quality iron ore.

The company's remaining projects are also on schedule, and within budget, and most are brownfield expansions, which have less risk. With less investment required, the company's capital expenditure for the current fiscal year is expected to drop by 25% to $16.1 billion. In addition, some of these projects are expected to start production in fiscal-year 2014, which will improve the company's production volume and revenue.

Along with lower capital expenditure, the company is also reducing its cash cost by increasing its production volume on existing facilities, which have a lower unit cost. In fiscal-year 2013, the company reduced its cash cost by about $2.7 billion and expects to reduce it further by increasing more volumes.

As BHP is spending less, the company expects it can increase its free cash flow, which it plans to return to investors. The company has always been known for providing good dividends. The table below shows the dividend growth for the last three years.

Year

Payout amount

Annual growth rate

2013

$2.32

3.6%

2012

$2.24

10.9%

2011

$2.02

16.1%

With the company's history of increasing the dividend, lower capital expenditure, and cash-cost reduction, I expect it will increase its free cash flow and return more value to the investors over the next few years.

Conclusion

In China, demand of higher-quality iron ore is expected to increase, which will cut the country's imports from countries such as Iran, Mexico, and Vietnam. BHP is in good position to increase sales of higher-quality iron ore lumps, for which it is already gaining customers.

By reducing capital expenditure and cash cost, the company wants to return more value to investors. With better prospects in China and more likely increases in the dividend, I recommend investors keep the stock in their portfolio.

Source: BHP Billiton: Stable Chinese Demand And Lower Capital Spending