Rio Tinto (NYSE:RIO) released its operations review report for 2012. The company said that it has beat its own estimates with respect to the production of iron ore, which constitutes the bulk of Rio’s portfolio. It reported record quarterly iron ore production, primarily due to increased production from its Pilbara mines in Australia.
Copper, bauxite, alumina, thermal coal, and titanium dioxide production were all higher in 2012 as compared to 2011. Only the production of aluminum and thermal coal showed a decline due to maintenance and other operational issues at Rio’s facilities.
The main takeaway from the report seems to be Rio’s continued assertion that it is focused on combating an increase in costs that have occurred relatively recently and is delivering high rates of return to shareholders. On the latter front, the company announced further sales of some more non-core businesses. The litmus test for retaining or selling a business in the portfolio has been its potential to generate high returns while simultaneously providing a significant scope for future expansion. The businesses which fail to meet both objectives simultaneously are potential divestiture candidates. 
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Global iron ore production figure at Rio’s facilities stood at 253 million tonnes, of which 199 million tonnes was its own share. This was 4% higher than the previous year’s figure. Most of Rio’s iron ore production comes from the mines in the Pilbara region of Australia. Production from this mine stood at 239 million tonnes, of which 191 million tonnes belonged to Rio. The shipments of iron ore stood at 247 million tonnes. Iron ore prices have risen steeply since September so we expect that to be reflected in Rio’s fourth quarter’s profit numbers. The rising demand from China is being touted as the main reason for rising prices.
You can check the effect of iron ore shipments on Rio’s Trefis valuation using our interactive graph below:
Copper production rose by 6% as compared to 2011, mainly due to recovery in ore grades at Kennecott Utah Copper and Escondida mines. Despite the growth, this fell short of Rio’s guidance of 560,000 tonnes, which was a revised figure issued in October after lowering of the initial guidance by 20,000 tonnes. The shortfall is being attributed to problems at the Palabora mine in South Africa, which Rio recently agreed to sell to a Sino-South African consortium. 
While the production of bauxite and alumina rose by 11% and 12% respectively, driven by increased third party demand for bauxite and expanded refining capacity at Yarwun, the production of aluminum declined by 10%. Aluminum production suffered as it took time to ramp up production to normal capacity following resolution of the Alma labor dispute.
Rio’s Oyu Tolgoi project in Mongolia is on track with the power supply agreement with China already in place. Commercial production is expected to begin by June 2013. However, Rio chose not to mention its troubles with the Mongolian government, which has proposed to increase its own share of royalty from sales and incorporated it into its revenue expectations for the annual budget. There are also increasingly shrill calls from within the government to change the ownership structure of the project with the Mongolian government owning the majority share. The situation is complicated by the fact that public opinion, at least in some quarters, seems to be against Rio Tinto. This might force the government to stick to its stance. At this point, nobody knows how the politics will play out, but we think that it is a significant risk factor. 
Strategy And Perspectives
From the latest available investor seminar material, we conclude that the company is giving importance to reducing costs across its operations, and isn’t likely to approve any new, large-scale capital-intensive projects in the near term. It, however, intends to remain on track with expansion plans in the Pilbara iron ore region. The aim is to expand extraction capacity to 283 million tonnes a year by the end of 2013 and to 353 million tonnes per year by 2015. The overall capital expenditure in future is expected to come down from this year’s figure. 
The company is also focusing heavily on leveraging technology to increase efficiency and keep costs under control. It already has a program in place called “Mine of the Future” with dedicated resources. In view of the burgeoning capital costs in the mining sector, this sounds like a good long-term strategy. ((2012 Investor Seminar- Question And Answer Session, Rio Tinto))
Rio is betting on rapid urbanization to drive demand for steel and thus iron ore. It considers China to be a key market until the mid-2020’s. It already derives about 80% of its earnings from iron ore, the bulk of which is sold in China. It wouldn’t be a stretch to say that Rio’s fortunes are closely correlated to China’s. Rio expects countries in South-East Asia and India to offset flat and then falling consumption in China after mid-2020’s.
Ceteris paribus, we agree with Rio’s assessment about future demand and think that average commodity prices will be higher than those in the past. Periodic bouts of volatility may persist but nonetheless, growth is expected to be higher on the whole. There is significant room for growth for economic development and construction demand in emerging markets given the low starting base in many of these places. This will be the main driver to the iron ore industry going forward.
We have a Trefis price estimate for Rio of $45 which will be revised once the fourth quarter earnings results are out.Notes: