Rio Tinto’s Full Year 2014 Earnings Preview: Robust Production Volumes And Cost Reduction Initiatives To Partially Offset Impact Of Low Commodity Prices

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Rio Tinto (NYSE:RIO) will release its results for the full year 2014 on February 12. We expect a sharp drop in commodity prices in 2014, particularly iron ore prices, to negatively impact the results of Rio Tinto, a diversified mining company and the world’s second largest iron ore miner. However, a sharp increase in iron ore production volumes and the company’s cost reduction efforts will partially offset the negative impact of lower commodity prices on the company’s results. Rio Tinto announces its earnings results semi-annually.  During the first half of the year, the company’s underlying earnings, which exclude the impact of one-time items on profits, rose 21% year-over-year to $5.12 billion. [1] The improvement in underlying earnings was driven by higher volumes, lower cash costs, and favorable exchange rate movements, which offset the fall in commodity prices. In this article, we will take a look at what to expect from the company’s full year 2014 results.

Weak Commodity 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. Benchmark 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. [2] Chinese steel demand growth is expected to slow to 2.7% in 2015, from 6.1% and 3% in 2013 and 2014, respectively. [3] Weak demand for steel has indirectly resulted in weak demand for iron ore.

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On the supply side, an expansion in production by major iron ore mining companies such as Vale, Rio Tinto, and BHP Billiton has created an oversupply situation. A combination of weak demand and oversupply is likely to result in weak iron ore prices in the near term. [4] Iron ore prices stood at $68 per dry metric ton (dmt) at the end of December 2014, around 50% lower as compared to prices at the end of December 2013. [5] The worldwide surplus of seaborne iron ore supply is expected to rise to 300 million tons in 2017, from an expected surplus of 175 million tons in 2015, and a surplus of 72 million tons and 14 million tons in 2014 and 2013, respectively. [6] [7] In view of the persisting oversupply situation, iron ore prices will remain subdued in the near term. The sharp drop in iron ore prices in 2014 will negatively impact Rio’s full year results.

Among other major commodities sold by Rio Tinto, copper was also characterized by weak demand and pricing environments in 2014. The weakness in demand for copper was mainly due to subdued demand from China, which accounts for nearly 40% of the global demand for the metal. [8]. Chinese GDP growth is expected to slow to 7.1% in 2015, from 7.3% and 7.7% in 2014 and 2013 respectively, with the deteriorating economic situation reflected in the prospects of the manufacturing sector, indicated by China’s Manufacturing Purchasing Managers Index (PMI) figures. [9] The Manufacturing 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 49.80 in January, and has ranged between 50.1 and 51.7 for the full year 2014. [10] Weakness in the manufacturing sector has contributed to weak demand for industrial metals, and consequently, the prices of these metals. London Metal Exchange (LME) copper prices averaged roughly $6,900 per ton in 2014, as compared to approximately $7,300 per ton in 2013. [11] Weakness in copper prices will negatively impact the company’s full year results.

Strong Growth in Production

Rio Tinto has already released its production data for the year 2014. Consolidated iron ore production at Rio’s facilities stood at 295.4 million tons, which was 11% higher year-over-year. [12] The sharp increase in volumes was primarily due to the ramp-up of production to a rate of 290 million tons per year (Mt/a) at Rio’s Pilbara operations in May 2014. [13] Located in Western Australia, the Pilbara iron ore mines represent nearly 95% of Rio’s global iron ore production. [14] A sharp increase in production volumes will lower average costs of production and boost margins as costs will be diluted over higher volumes.

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. [14] The company’s cost of production stands at around $50 per ton. [15] Rio Tinto, with its low-cost iron ore deposits, can continue to operate profitably in the prevailing subdued iron ore pricing environment.  However, current levels of iron ore prices 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 the margins of high-cost seaborne iron ore suppliers.  A further reduction in prices may see a curtailment in operations by high-cost iron ore producers. [16] This will constrain supply and benefit low cost producers such as Rio.

Cost Reduction

In addition to expanding iron ore production capacity, the company targeted $3 billion in operating cash cost savings in 2014, as compared to its 2012 levels. [17] These efforts will boost the company’s margins and allow it to operate more competitively in the prevailing commodity pricing environment. The company also lowered its capital expenditure budget from $12.9 billion in 2013 to $8.5 billion in 2014, and intends to further reduce it to $8 billion in 2015. [17]  These efforts will further enhance the company’s flexibility to operate in the prevailing commodity pricing environment.

Thus, we expect Rio’s full year results to be negatively impacted by the fall in commodity prices. However, the negative impact of low commodity prices will be partially offset by a strong growth in production volumes as well as the company’s cost reduction initiatives.

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Notes:
  1. Half Year Results 2014, Rio Tinto Media Release []
  2. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg []
  3. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association []
  4. BHP, Rio Gamble with Stacked Iron Ore Deck, Mineweb []
  5. Iron Ore Spot Prices, Y Charts []
  6. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg []
  7. Iron Ore Caps 2014 Loss as Morgan Stanley Says Worst Over, Bloomberg []
  8. Copper Ends at 5-Month Low on China Worries, Wall Street Journal []
  9. Goldman Sachs cuts China growth forecast sharply, Market Watch []
  10. China Manufacturing PMI, Trading Economics []
  11. LME Copper Prices, LME []
  12. Fourth Quarter 2014 Operations Review, Rio Tinto Media Release []
  13. Rio Tinto announces landmark Pilbara iron ore operational performance ahead of schedule, Rio Tinto Media Release []
  14. Rio Tinto’s 2013 20-F, SEC [] []
  15. BHP, Rio Gamble With A Stacked Iron Ore Deck, Mineweb []
  16. Iron Ore Prices Sink, Driven by Market Worries, Wall Street Journal []
  17. Rio Tinto Investor Presentation, Rio Tinto Website [] []