Rio Tinto (NYSE:RIO), China’s Chalco and the World Bank have signed a draft agreement with the Guinean government to delay first production from the ambitious Simandou iron ore project by three years to 2018 from the original target of 2015. Rio, Chalco and the World Bank own 50%, 45% and 5% in Simandou respectively.
The project has been held up over infrastructure financing issues. The agreement focuses on the terms and conditions that will govern funding and construction of a 650 km long railway line to a port from the mine. This draft agreement will serve as the basis to work towards a binding agreement by the end of the year. 
While some analysts think that the delay would reduce the internal rate of return from the project, we think that it could be a blessing in disguise. Iron ore prices are expected to bottom out around 2018 due to a supply surge and an absence of a corresponding increase in demand. Also, given that Rio is running a tight ship on costs and capital expenditure at the moment, the delay may give the company time to generate enough cash on the balance sheet to fund the project.
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Why Is Simandou Important?
Simandou is among the world’s largest untapped high quality iron ore deposits. At full production levels, Rio is expected to export about 95 million tonnes of iron ore annually from here. This is about one-third of its total present capacity at the moment. Apart from the Oyu Tolgoi copper-gold project in Mongolia, it is the only significant growth project in its pipeline at the moment. Given that Vale, the largest producer of iron ore in the world, owns the other half of the Simandou concession, it is imperative that Rio doesn’t fall behind. In the iron ore business, economies of scale grant companies pricing power in the market and lower costs. 
Why The Delay?
The earlier deadline of 2015 for commencing production was quite ambitious to begin with. Continuous wrangling with the Guinean government due to regime changes, which led to policy changes, worsened the situation. Earlier this year, there were reports that Rio had unofficially frozen the Simandou project over financing issues. The bone of contention seemed to be the Guinean government’s reluctance to commit half the funds required for construction of the crucial railway line to transport iron ore to a port 650 km away despite a previously agreed upon obligation. The cost of construction has been pegged at $10 billion and Rio had explicitly expressed its inability to bear any extra costs. While a cheaper transportation option that involved transporting the ore to a port in neighboring Liberia was available, the Guinean government denied permission for the same in expectation that a new railway line within Guinea could generate economic benefits for the local populace. For a background and history of the Simandou project, you can read this note we wrote earlier this year.
The new draft agreement seeks to break the deadlock over financing by allowing the Guinean government to bring in a third party to fully fund the construction of the railway and port. Effectively, this frees the government from its obligation to fund 51% of the infrastructure. According to Bloomberg, the Chinese government is considering whether to fund the construction of the infrastructure. 
Is The Delay Bad News?
Not necessarily. Some analysts have expressed an opinion that the internal rate of return from the Simandou project will be lowered as a result of the delay. However, we think that this analysis doesn’t take into account the possible repercussions for Rio’s iron ore business as a whole. A supply surge in the iron ore market is expected over the next few years as expansion projects by majors like Rio, Vale and BHP Billiton fructify. Rio itself is poised to expand its production capacity to 360 million tonnes per year by end of 2015, from the present level of 290 million tonnes. This doesn’t include the contribution from Simandou. 
Australia is a major exporter of iron ore to China and other countries so its economic agencies track the iron ore market very closely. According to the Bureau of Resource and Energy Economics (BREE), the official Australian commodities forecasting agency, iron ore prices will decline going forward and reach its lowest levels around 2018. This is due to a lot of additional production capacity scheduled to come online in this period and a non-commensurate expected rise in demand. Beyond 2018, the balance between demand and supply is likely to be more even. 
Thus, by the time Simandou comes online, iron ore prices may be on an uptick. If production from Simandou were coming online as originally planned, price expectations would be lowered further.
We have a Trefis price estimate for Rio of $55.Notes:
- Rio admits African delays, The Australian [↩]
- Simandou start-up delayed to late 2018, Mining.com [↩]
- China Said to Mull Funding Rail for Rio’s Simandou Iron Project, Bloomberg [↩]
- Rio digs a hole for small China suppliers, Business Spectator [↩]
- Australia predicts fall in iron ore price, Financial Times [↩]