Pairs Trading – Buy BHP, Sell RIO

The recovery in iron ore prices since August appears to have driven an outperformance by RIO over BHP in Australia. However, both companies are also listed in London, and the degree of the outperformance is significantly smaller. Combined with stronger copper and gold prices, there is a case to buy BHP and sell RIO.

Both RIO and BHP are major global mining companies, but their commodity portfolios are different. Iron ore contributes around 72% of RIO’s revenue and only approximately 22% of BHP’s. BHP’s more diversified operations mean copper, gold and energy commodities are also key revenue drivers. A focus on iron ore prices could be one of the key reasons RIO has outperformed, but this may be ignoring the recovery in copper and gold prices.

Iron fell to U$86 a tonne in August (62% fines, China), and bounced to current levels around $120. Copper dropped in October, but current prices around U$3.50 a pound are still higher than August’s $3.28. Similarly, gold is trading around U$1,725 an ounce, up from August prices around $1,575.

Even more curious is the different treatment of these improvements in Australia and the UK. Here are the charts:

BHP vs RIO, Daily (Australia)

Source: CMC Tracker

BHP and RIO tend to move together – the one-year, daily correlation is 0.86 (on a scale of -1 to +1). Note that from late August, RIO’s price is more than 8% better than BHP’s. Now, take a look at the UK:

BHP vs RIO, Daily (UK)

Source: CMC Tracker

The outperformance in the UK is less than 4% over the same period.

Traders may see this as a relative value opportunity. Traders taking a “value neutral” approach (same dollar value on the long and short positions), will divide the appropriate dollar amount by the current price. As an example:

BUY 15,000 BHP at current prices  (approx $500,000 divided by $33.36)

and simultaneously

SELL 8,800 RIO at current prices  (approx $500,000 divided by $56.90)

 

About michaelmccarthycmc

Chief Market Strategist - CMC Markets and Stockbroking Regular on ABC, BBC, Bloomberg, Channel TEN, CNBC, SBS and SKY
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