Rio Tinto Operations Review: Sharp Rise in Iron Ore Volumes

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Rio Tinto (NYSE:RIO) has released its operations review for the second quarter and first half of the year. Iron ore production and shipments rose sharply in the first half of the year, as compared to the corresponding period last year. This is consistent with the company’s strategy to expand iron ore production, despite a subdued iron ore pricing environment. The company is banking upon economies of scale to drive its results, capitalizing on its low-cost iron ore deposits.

Besides iron ore, the production of copper, hard coking coal and thermal coal rose in the first half of the year, as compared to the corresponding period last year. Aluminum production remained flat, while bauxite production declined during the first half.

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Operational Performance

Iron ore production in the first half of the year at Rio’s facilities stood at 139.5 million tons, of which Rio’s share was 109.9 million tons. Production was 10% higher year-over-year. The sharp increase in volumes was primarily due to the ramp up of production to a run rate of 290 million tons per year (Mt/a) at Rio’s Pilbara operations in May, which was two months ahead of schedule. The Pilbara iron ore mines represent nearly 95% of Rio’s global iron ore production. Global iron ore shipments stood at 142.4 million tons in the first half of the year, up 20% year-over-year. Shipments exceeded production, as inventory built up ahead of the expansion of port and rail infrastructure at the Pilbara system of mines was drawn. [1]

Copper production rose to 323,000 tons in the first half of the year, 23% higher compared to the corresponding period last year, excluding the impact of asset divestments in 2013. This was driven by higher grades and concentrator recoveries at Rio’s Kennecott Utah Copper operations and the ramp up of production at the Oyu Tolgoi mines. ((Second quarter 2014 operations review, Rio Tinto Website))

Bauxite production was 2% lower in the first half of the year, compared to the corresponding period last year, as the Gove mine lowered production in response to the planned curtailment of the Gove alumina refinery in the first half of the year. Aluminum production in the first half remained flat on a year-over-year basis, with productivity gains offsetting the impact from the closure of the Shawinigan smelter in November 2013. ((Second quarter 2014 operations review, Rio Tinto Website))

Hard coking coal production rose 9%, driven by the higher volumes following the completion of the Kestrel mine expansion project in the second half of 2013. Thermal coal production rose 6%, with higher production from the Hunter Valley and Hail Creek mines offsetting the loss in volumes from the completion of the divestment of Rio’s 50.1% interest in the Clermont mine in Q2 2014.((Second quarter 2014 operations review, Rio Tinto Website))

Strategy

Rio Tinto is expanding capacity at its iron ore mines, despite a subdued iron ore pricing environment. The company is banking upon robust Chinese demand for iron ore in the long term, driven by rapid urbanization. ((Rio Tinto’s 2013 20-F, SEC))

Global iron ore prices have plummeted over the last year or so, due to expansion in production by major mining companies. Supply has outpaced demand resulting in an oversupply situation. However, Rio Tinto with its low-cost iron ore deposits can continue to operate profitably in the prevailing subdued iron ore pricing environment. Rio’s cost of production stands at around $50 per ton.((BHP, Rio Gamble With A Stacked Iron Ore Deck, Mineweb)) Iron ore spot prices stood at $92.74 per dry metric ton (dmt) at the end of June 2014, about 19.2% lower than a year ago. ((Iron Ore Spot Price Chart, YCharts)) The outlook on iron ore prices remains bleak in the near term, in view of the oversupply situation. Falling iron ore prices in an oversupplied market will put pressure on the margins of domestic Chinese iron ore producers, which have higher costs of production as compared to Rio, 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. [2] This will constrain supply and benefit low cost producers such as Rio.

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 from the current 290Mt/a capacity have already been approved. ((Rio Tinto’s 2013 20-F, SEC)) Rail infrastructure expansion for the expanded 360 Mt/a production capacity has already been completed, with port infrastructure expansion for the same expected to be completed by the end of the first half of 2015. ((Second quarter 2014 operations review, Rio Tinto Website))

The success of Rio’s high iron ore volumes strategy will depend upon the strength of Chinese iron ore demand in the long term. With the country consciously reorienting its economy from an investment led model to a consumption led model, it remains to be seen whether Rio’s expectations of sustained Chinese demand are well-founded.

In addition to expanding iron ore production capacity, the company is also targeting cost savings with $3 billion in operating cash cost reductions planned for 2014, as compared to 2012 levels. The company also intends to reduce capital expenditure, through a combination of lower sustaining capital expenditure and focusing expansion capital expenditure on projects that offer the best returns. The company intends to lower capital expenditure from $12.9 billion in 2013 to $11 billion in 2014, and further to $8 billion in 2015. These efforts are aimed at operating competitively in a subdued iron ore pricing environment. ((Rio Tinto’s 2013 20-F, SEC))

The company is set to announce its half-yearly results on August 7. We currently have a $52.32 Trefis price estimate for Rio Tinto. We will update this in the light of the earnings announcement.

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Notes:
  1. Second quarter 2014 operations review, Rio Tinto Website []
  2. Iron Ore Prices Sink, Driven by Market Worries, Wall Street Journal []