Rio Tinto Bets Big On Iron Ore Volumes

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Rio Tinto (NYSE:RIO) recently announced a major production milestone for its Pilbara system of iron ore mines. The ramp-up of production to 290 million tonnes per annum (Mt/a) at the Pilbara mines was completed earlier in May, nearly two months ahead of schedule. [1]

The Pilbara iron ore mines constitute the bulk of Rio Tinto’s iron ore operations. These mines accounted for around 95% of Rio’s global iron ore production in Q1 2014. These mines had a rated capacity of 237 Mt/a in Q4 2012 before the expansion to 290Mt/a took place. [2]

The move to expand production capacity may seem at odds with faltering demand and prices of iron ore over the course of last year. However, the company is confident of the long-term strength of iron ore demand, primarily from Asia. Rio believes economies of scale will drive its results, even in an environment of low iron ore prices. In this article we will take a closer look at the rationale behind Rio’s strategy.

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Iron Ore Prices

Iron ore is the chief raw material in the steel making industry. Thus, demand for iron ore by the steel industry plays a major role in determining iron ore prices. International iron ore prices are largely determined by Chinese demand as China is the largest consumer of iron ore in the world. It accounts for more than 60% of seaborne iron ore trade. Flagging demand for iron ore from China in the wake of the economic slowdown has put downward pressure on iron ore prices. According to data from China’s National Bureau of Statistics, growth in investment, factory output and retail sales has slowed to multi-year lows in the first two months of the year. The Chinese government crackdown on polluting steel plants has forced many of them to shut down. In addition, the tightening of credit by Chinese banks to steel plants that are not performing well will affect their ability to purchase iron ore and thus overall demand for the commodity. This has resulted in an inventory build-up at Chinese ports which will further curtail imports. Further, the Chinese leadership has proposed structural reforms of the economy, shifting the emphasis from investment and export-driven growth to services and consumption-led growth. Such a transformation of the Chinese economy may negatively impact Chinese demand for iron ore in the long run. [3]

The negative sentiment surrounding the strength of iron ore demand has driven down prices. Iron ore spot prices stood at $114.58/dry metric tonne (dmt) at the end of April 2014, about 16.6% lower than a year ago. Though the outlook on iron ore prices remains bleak in the near term, the long-term demand remains robust. This is what Rio and other global majors are counting on. [4]

High Volumes Strategy

Despite the weakness in iron ore prices, Rio has continued with planned capacity expansion to its iron ore operations. The company is banking on robust demand for iron ore in the long term and low cost of production in the near term to boost its prospects.

The company expects long-term demand for iron ore, particularly from Asia, to remain robust. Continued urbanization and industrialization in large markets such as China and India is expected to prop up demand for iron ore. As per a report by McKinsey, China’s urban population is expected to rise by about 350 million by 2025. India is expected to add 215 million to its urban population by 2025. These trends in urbanization and industrialization are expected to drive up demand for iron ore over the coming years. [5]

Expansion in iron ore production by iron ore majors such as Rio Tinto and BHP Billiton has put downward pressure on prices due to oversupply. However, Rio Tinto can easily maintain profitable iron ore operations at current price levels. [6]

Rio Tinto has one of the lowest cost iron ore reserves in the world. Its cash costs for iron ore production stood at $ 20.80/tonne in 2013. If we take other costs into account as well, Rio can maintain profitable iron ore operations even at iron ore prices of $50/tonne. [7]

However, falling iron ore prices in an oversupplied market will put pressure on margins of domestic Chinese iron ore suppliers as well as high-cost seaborne iron ore suppliers. A further reduction in prices may see a curtailment in operations by high-cost iron ore producers. This will constrain supply and benefit low cost producers such as Rio.

The Road Ahead

Rio Tinto is planning to further expand the production capacity of its Pilbara iron ore operations. Plans to increase mine production capacity to 360 Mt/a by 2017 have already been approved. Thus, the strategy for Rio Tinto is clear. It is betting heavily on strong long-term demand for iron ore and its low costs of production to tackle the low price environment that is expected to persist in the near term. [8]

Iron ore prices closed below the psychological $100/dmt mark a few days ago, mainly due to fears of oversupply led by expansion in production by major iron ore miners. With the downward trend in prices set to continue, high cost producers may be forced to curtail production. This could boost Rio’s near term prospects. [9]

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Notes:
  1. Rio Tinto Announces Landmark Pilbara Iron Ore Operational Performance Ahead Of Schedule, Rio Tinto Media Release []
  2. Rio Tinto’s Q1 2014 Operations Review, SEC []
  3. The Latest Iron Ore Price Slump: Causes and Effects, Forbes []
  4. Iron Ore Spot Price Chart, YCharts []
  5. Preparing For China’s Urban Billion, McKinsey []
  6. BHP, Rio Gamble With A Stacked Iron Ore Deck, Mineweb []
  7. Rio Tinto Chartbook, Rio Tinto Website []
  8. Rio Tinto’s 2013 20-F, SEC []
  9. Iron Ore Prices Sink, Driven By Market Worries, The Wall Street Journal []