Rio has made significant cuts to its production costs.

Rio has made significant cuts to its production costs.

Rio Tinto and BHP Billiton are major contributors to the supply-side pressure that is bearing down on the iron ore price.

The paradox, good for them and their shareholders, is that they are also the lowest-cost iron ore miners and best placed to benefit from a purge of higher-cost producers that a lower iron ore price produces.

With its spending reined in, Rio is as good as promising that its payout to shareholders will jump in February when it posts its full-year result.

The mining group has lifted annual production at its mines from 240 million tonnes to 290 million tonnes in a year. It is aiming at 360 million tonnes, and as chief executive Sam Walsh notes, a supply-side squeeze is under way.

About 85 million tonnes of iron ore production has already been shut down in China, he says. China used to source 50 per cent of its iron ore domestically. Now it sources 20 per cent domestically: it's not hard to guess which companies are filling the gap.

Iron ore earnings accounted for 48 per cent of Rio’s revenue and 96.4 per cent of its underlying net earnings in 2013. Lower prices cut the division’s earnings by $US974 million in the latest June half but it still accounted for 49.3 per cent of group revenue and 91.5 per cent of Rio’s 21 per cent higher $US5.1 billion June-half profit.

Cost cuts, taxation fillips and currency movements also helped the iron ore division, but it was basically a volume story. Rio's share of production rose by 9 per cent compared with the June half last year, and iron ore sales from the mines it controls were up 20 per cent, to a record 142 million tonnes.

Iron ore averaged $US128.30 a tonne in 2012, and averaged $US135.22 a tonne in 2013. It finished last year at $US134.20 a tonne, but then cracked, falling below $US120 a tonne by mid-February, and below $US100 a tonne on May 19. It hit a low of $US89 a tonne in mid-June, and then recovered to about $US95 a tonne.

This year's price chart looks very different to the ‘‘flash crash’’ of 2012.

In 2012, iron ore crashed from above $US130 a tonne in mid-July to a low of $US86.70 a tonne on September 5. It then recovered just as quickly, and closed out the year at $US144.90.

This year the downturn has been lengthier. The consensus is that a bounce back up above $US100 a tonne is unlikely as the supply-side squeeze continues.

Goldman Sachs calculated recently that iron ore supply growth was running at three times the growth in iron ore demand from steel mills.

The market was still in the early stages of oversupply, it said, and while supply growth was expected to slow in the December half, the second half of the year was also a period of weak demand.

Supply growth would accelerate again in 2015, Goldman predicted, adding that a sub-$US100 a tonne price was now the consensus view. The investment bank sees nothing in the current market settings to change its view that the iron ore price will be $US80 a tonne next year.

Citigroup says there are two competing views of the iron ore market.

The first is that higher-cost producers, including mines in China, will close down quickly as lower-cost sea-borne suppliers led by Australia's two iron ore giants, Rio and BHP, continue to ramp up production and shipments, tightening the supply-side squeeze that Sam Walsh notes has already begun.

The second theory is that the squeeze and the price improvement it delivers once high-cost producers have exited will take longer than expected. Production in China and elsewhere is "sticky" on that scenario, and the iron ore price needs to fall below $US80 a tonne for ‘‘an extended period’’ before the high-cost producers quit.

The second scenario delivers more pressure to smaller, higher-cost miners, including ones that emerged in Australia during the mining boom.

Rio and BHP are cash positive even if the iron ore price falls to $US50 a tonne. It is why they are boosting production. The smaller producers are on the edge at US$80 a tonne, in trouble if the price goes lower – and their lower-grade ore sells for less than the high-grade ore that Rio and BHP dig up.

There are precedents for the more bearish scenario, too. Citi says that in the coal industry, for example, break-even prices for higher-cost miners were repeatedly breached before major production cuts occurred.