Will Rio’s High Production Volumes Strategy Succeed ?

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Iron ore prices have tumbled over the course of the last year or so. Iron ore prices stood at $81 per dry metric ton (dmt) at the end of October, around 39% lower than at the corresponding point of time last year. [1] Falling iron ore prices have had a major negative impact upon the profitability of operations of mining companies producing the commodity. The response of companies has varied from cost-cutting initiatives to idling of high-cost mines.

The primary reason for the fall in iron ore prices has been an oversupply situation, created due to a steady increase in production in the face of weakness in demand for the commodity. Global mining giants such as Rio Tinto (NYSE:RIO) have plans to further expand their iron ore output over the course of the next few years. In this article, we will examine whether the high production volumes strategy makes sense from the company’s perspective.

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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 price. China is the largest producer of steel in the world, accounting for around 49% of global steel production in 2013. [2] International iron ore prices are largely determined by Chinese demand, since China is also the largest consumer of iron ore in the world. It accounts for more than 60% of the seaborne iron ore trade. [3]

Weak demand for steel in China has translated into weak demand for iron ore. Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. [4]  A slowdown in economic growth has tempered the demand for steel. China’s GDP growth is expected to slow to 7.3% and 7.1% in 2014 and 2015 respectively, from 7.7% in 2013. [5] The Chinese steel industry is characterized by overcapacity. Capacity utilization for the Chinese steel industry stood at 72% in 2013. [6] The Chinese government is cracking down on steel plants that utilize obsolete steel technology, in its bid to rein in air pollution and tackle overcapacity in its domestic steel industry. The government plans to close down 28.7 million tons of outdated steel smelting capacity in 2014. [6] The Chinese leadership has also proposed structural reforms of the economy, shifting the emphasis from investment and export driven growth, which was mainly responsible for the robust growth in Chinese steel production, to services and consumption led growth. [7]  Such a transformation of the Chinese economy may negatively impact Chinese demand for steel in the long term.

The weak Chinese economic prospects are captured by the Manufacturing Purchasing Managers’ Index (PMI). The Manufacturing Purchasing Managers Index (PMI) measures business conditions in the manufacturing sector of the concerned economy. When the PMI is above 50, it indicates growth in business activity, whereas a value below 50 indicates a contraction. Chinese Manufacturing PMI, reported by China’s National Bureau of Statistics, stood at 50.8 for October, and has ranged between 50.2 and 51.7 for the whole year. [8] With weak Chinese manufacturing growth, demand for steel is expected to remain subdued in China.

On the supply side, expansion in production by 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. [9] As per Goldman Sachs, the worldwide surplus of seaborne iron ore supply will rise to 175 million tons in 2015, from an expected 72 million tons for 2014 and 14 million tons for 2013. [10] In view of the persisting oversupply situation, iron ore prices will remain subdued in the near term.

Rio’s High Production Volumes Strategy

Rio Tinto’s iron ore mining operation in the Pilbara region of Western Australia, which accounts for around 95% of the company’s global iron ore production, ramped up its production to a rate of 290 million tons per annum (Mt/a) in May. [11] The company is planning to further expand the production capacity of its Pilbara iron ore operations. Plans to increase  production capacity to 360 Mt/a by 2017 have already been approved. [12]

Rio Tinto and other major mining companies are betting on rapid rates of industrialization and urbanization in emerging ecnonmies led by China to drive global demand for iron ore. Major mining companies have bet on Chinese steel production peaking around 2030. [13] However, as per the World Steel Association, Chinese steel production may peak in the next three years. [13] If the World Steel Association’s estimate turns out to be correct, iron ore mining companies may have grossly overestimated the demand for iron ore.

Iron ore majors such as Rio Tinto are banking upon their low-cost iron ore deposits to maintain profitability in a subdued iron ore pricing environment. The cost of producing iron ore for Rio Tinto is around $50 per ton. Thus, the company can continue to produce profitably at current levels of iron ore prices. [9] However, the current level of iron ore prices is impacting higher-cost iron ore producers. Around a quarter of China’s iron ore production capacity is unprofitable at levels  below $90 per ton. [14] If present levels of iron ore prices persist, there are likely to be closures of high-cost production capacity across the world. This would favor low-cost iron ore producers such as Rio Tinto.

Thus, Rio Tinto is banking upon its low-cost iron ore deposits to operate profitably in the prevailing subdued iron ore pricing environment. However, over the long term, the fortunes of the company are tied to the continued growth of steel production in China. The company is betting on China to absorb the wave of fresh iron ore supply over the coming years. Rio’s prospects over the long term may very well hinge upon how realistic this expectation turns out to be.

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Notes:
  1. Iron Ore Spot Prices, Y Charts []
  2. Cliffs Natural Resources 2013 10-K, SEC []
  3. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg []
  4. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association []
  5. Goldman Sachs cuts China growth forecast sharply, Market Watch []
  6. China to close more steel capacity, though still small fraction, Reuters [] []
  7. China: From Investment to Consumption-Led Growth, Institute Of Peace And Conflict Studies []
  8. China Manufacturing PMI, Trading Economics []
  9. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb [] []
  10. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg []
  11. Rio Tinto Announces Landmark Pilbara Iron Ore Operational Performance Ahead Of Schedule, Rio Tinto Media Release []
  12. Rio Tinto’s 2013 20-F, SEC []
  13. As China Peak Steel Looms, Miners Sweat On $120 Billion Bet, Bloomberg [] []
  14. Iron Ore Seen Finding Floor at $90 by Citi as Exports Steady, Bloomberg []