Rio Tinto Earnings Preview: Low Iron Ore Prices To Weigh On Results

Rio Tinto (NYSE:RIO) will release its half-yearly results Thursday, August 7. The company has already released its operations review for the second quarter and the first half of the year. The company’s iron ore production rose sharply in the first half. This is a part of Rio’s long term strategy to significantly boost its production capacity. However, lower iron ore prices in the second quarter and the first half of the year will negatively impact the company’s results.

See our complete analysis for Rio Tinto

Iron Ore Prices

Iron ore is an important raw material for the steel industry. Thus, demand for iron ore by the steel industry plays a major role in determining its 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 the seaborne iron ore trade. ^[1] Flagging demand for iron ore from China in the wake of an economic slowdown earlier on in the year 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 slowed to multi-year lows in the first two months of the year. ^[2] A Chinese government crackdown on polluting steel plants has forced many of them to shut down. In addition, tightening of credit by Chinese banks to steel mills that are not performing well will negatively impact these mills’ prospects. ^[3] Furthermore, 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 steel in the long term. Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. ^[4] Weak demand for steel has indirectly resulted in weak demand for iron ore.

On the supply side, expansion in production by iron ore majors such as Rio Tinto and BHP Billiton has created an oversupply situation. A combination of weak demand and oversupply is likely to result in lower iron ore prices in the near term. ^[5] Iron ore spot prices stood at $92.74 per ton at the end of June 2014, around 19% lower than the value a year ago. ^[6] As revenues from iron ore sales account for around half of the company’s revenues, lower iron ore prices will weigh on the company’s half-yearly results.

Operations Review

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. ^[7]

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 loss of production 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))

High Volumes 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))

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% 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. ^[8] 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))

Cost Reduction and Disciplined Capital Allocation

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)) In addition, the company has divested a number of non-core assets. The completion of its stake sale in the Clermont mine in the second quarter represents the culmination of $3.5 billion in divestments announced in 2013. ((Rio Tinto’s 2013 20-F, SEC))

Expectations from Conference Call

With iron ore prices expected to remain subdued in the near term, we would like to hear from the company management if any more divestments of non-core assets are in the pipeline. We would also like to know the details of the company’s cost reduction initiatives. This would shed some light on the road ahead for Rio Tinto.

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1. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg [↩]
2. China Premier Warns On Economic Slowdown As Data Fans Stimulus Talk, Reuters [↩]
3. The Latest Iron Ore Price Slump: Causes and Effects, Forbes [↩]
4. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association [↩]
5. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb [↩]
6. Iron Ore Spot Price Chart, Y Charts [↩]
7. Second quarter 2014 operations review, Rio Tinto Website [↩]
8. Iron Ore Prices Sink, Driven by Market Worries, Wall Street Journal [↩]