Cost Reduction And Disciplined Capital Allocation Complement Rio’s High Volumes Strategy

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Rio Tinto (NYSE:RIO) recently announced the completion of sale of its 50.1% interest in the Clermont Mine to GS Coal Pty Ltd for $1.015 billion. GS Coal Pty Ltd is a company that is jointly owned by Glencore and Sumitomo Corporation. The Clermont Mine, located in the Australian state of Queensland, produces thermal coal. [1]

The sale of Rio’s stake in the Clermont mine is part of the company’s broader strategy to operate in an environment of falling commodity prices. We will take a closer look at this strategy in this article. The company is focused on cutting costs, as well as adopting a disciplined approach to capital allocation. This has involved selling off non-core assets and deploying capital in projects that will generate better returns. These efforts complement Rio’s plans to significantly boost its iron ore production. The company is expecting to lower unit costs through reaping the benefits of economies of scale – taking advantage of its low-cost iron ore deposits. We had covered this in an earlier article. [2]

See our complete analysis for Rio Tinto here

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Iron Ore And Coal 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 since 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. [3] The Chinese government’s 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, the 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. [4]

On the supply side, iron ore majors such as Rio Tinto and BHP Billiton have expanded production of the ore. These companies are banking on higher volumes to compensate for lower prices and drive profits given their low costs of production of iron ore. These companies are betting on continued strength in iron ore demand over the long term. The main drivers of such long term demand are increasing levels of urbanization and industrialization in developing and emerging economies, particularly China and India. However, given the weak demand scenario, at least in the near term, expanded production by iron ore majors has resulted in an oversupply situation, which is expected to keep prices subdued in the near term. [5]

The negative sentiment surrounding the strength of iron ore demand has driven down prices. Iron ore spot prices stood at $100.56 per dry metric ton (dmt) at the end of May 2014, about 18.9% lower than a year ago. The outlook on iron ore prices remains bleak in the near term, with the oversupply situation expected to persist. [6]

Demand for both metallurgical and thermal coal has fallen as well. Weaker demand from major consumers of thermal coal, China and India, has put downward pressure on thermal coal prices. In addition, Chinese efforts to shift towards natural gas for energy generation may also affect demand going forward. [7]  China is also the largest consumer of metallurgical coal in the world. Faltering demand for the commodity by the Chinese steel making industry along with lower demand from other major consumers such as Japan and the EU has put downward pressure on prices. Falling demand coupled with an oversupply situation due to expansion in production by major coal mining companies has resulted in plummeting coal prices. [8] This has negatively impacted Rio’s coal mining business.

Cost Savings And Disciplined Capital Allocation

Rio Tinto made significant headway in its cost saving efforts in 2013. The company reported $2.3 billion in savings in operating cash costs over the previous year. [9] These savings reflect improvements in unit cost of goods sold for operating assets and improvements in operating costs for central functions. The company is targeting further reductions to its operating cash costs, targeting savings of around $3 billion in 2014, as compared to operating cash costs in 2012. ((Rio Tinto’s 2013 20-F, SEC))

Rio Tinto also reduced exploration and evaluation spending by about $1 billion in 2013, as compared to the previous year. [9] The company is focusing its exploration and evaluation efforts on those projects which can potentially deliver the best value in the medium-term, while reducing spending on longer-dated options. Going forward, the company will endeavor to sustain the lower exploration and evaluation spending in 2014.

In addition, the company has divested a number of non-core assets. The recent completion of its stake sale in the Clermont mine represents the culmination of $3.5 billion in divestments announced in 2013. ((Rio Tinto’s 2013 20-F, SEC)) The company is deploying capital into projects that offer better returns. For example, along with the announcement to divest its stake in the Clermont mine, Rio Tinto also announced the completion of the $2 billion Kestrel Mine Extension project in 2013. This extension will add 20 years to the life of the Kestrel coal mine. ((Rio Tinto’s 2013 20-F, SEC)) The company’s focus on projects that offer the best returns has also resulted in a substantial reduction in capital expenditure. Rio reduced its capital expenditure by 26% to $12.9 billion in 2013, compared to $17.6 billion in 2012. The company is targeting further reductions in capital expenditure to around $11 billion in 2014, and to $8 billion in 2015, while delivering steady growth. ((Rio Tinto’s 2013 20-F, SEC))

The Road Ahead

With the challenging pricing environment for Rio’s major commodities expected to continue in the near term, the company intends to continue to reduce costs and focus on its core assets. Disciplined capital allocation will continue to be the mantra for Rio Tinto. In addition, the company will look to reap the benefits of economies of scale with high volumes from its core assets. These taken together will define the road ahead for Rio Tinto.

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Notes:
  1. Sale Of Interest in Clermont Mine Completed, Rio Tinto Media Release []
  2. Rio Bets Big On Iron Ore Volumes, Trefis []
  3. Chinese Premier Warns On Economic Slowdown As Data Fans Stimulus Talk, Reuters []
  4. The Latest Iron Ore Price Slump: Causes and Effects, Forbes []
  5. BHP, Rio Gamble With A Stacked Iron Ore Deck, Mineweb []
  6. Iron Ore Spot Price Chart, YCharts []
  7. Thermal Coal Prices To Drop Further On Oversupply, Weak Demand, Reuters []
  8. Coking coal price crashes through $100, Mining.com []
  9. Rio Tinto’s 2013 20-F, SEC [] []