How Rio Tinto Would Benefit From A Recovery In Iron Ore Prices

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Iron ore prices have declined sharply over the course of the last year or so. Benchmark 62% Fe iron ore fines prices stood at $63 per dry metric ton (dmt) at the end of February, around 47% lower on a year-over-year basis [1]. Iron ore prices have declined due to a combination of weakness in demand and rising global iron ore production, resulting in an oversupply situation. This has negatively impacted the prospects of major iron ore mining companies such as Rio Tinto (NYSE:RIO). Rio is the second largest producer of iron ore in the world.

We expect iron ore prices to remain subdued in the near term, with prices recovering gradually only after the global supply glut dissipates. However, there is a possibility of a sharper V-shaped recovery in prices, if sufficient high-cost iron ore supply goes out of the market. The current level of iron ore prices is too low to sustain significant quantities of high-cost iron ore production, particularly from domestic Chinese iron ore producers. Production cutbacks in response to low prices are likely to result in a more favorable demand-supply equation, which would boost iron ore prices. Such a scenario would significantly boost the prospects of Rio Tinto. In this article, we will explore the impact of a V-shaped recovery in iron ore prices on the company.

See our complete analysis for Rio Tinto

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Impact of V-shaped Recovery in Iron Ore Prices on Rio Tinto

From the perspective of iron ore demand, China is the most significant player, accounting for over 60% of the seaborne iron ore trade. [2] Iron ore is primarily used in the production of steel, and therefore demand for iron ore by the steel industry largely constitutes the overall demand for the commodity. With Chinese economic growth slowing, the demand for steel, which is largely correlated with macroeconomic growth, is also slowing. As per the latest IMF estimates, Chinese GDP growth is expected to slow to 6.8% and 6.3% in 2015 and 2016, respectively, from 7.4% in 2014. [3] As per estimates by the World Steel Association, Chinese steel demand growth is expected to slow to 2.7% in 2015, from 6.1% and 3% in 2013 and 2014, respectively. [4] Thus, demand for iron ore in the near term is unlikely to grow at rates seen over the last couple of years.

The supply side is characterized by an expansion in production by major iron ore mining companies. Companies such as Vale, Rio Tinto, and BHP Billiton are rapidly ramping up their iron ore production, despite weakness in demand. These companies have low-cost iron ore deposits and are able to operate profitably even at current price levels. [5] These companies are betting on the long-term strength of iron ore demand from China, and the curtailment of high-cost iron ore production capacity, to bring the demand-supply equation back into balance. As per projections by major Wall Street banks, 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]

The world’s lowest cost iron ore miners such as Rio break even at price levels below $50 per ton. [8] Thus, these companies can continue to produce profitably even if prices fall further. However, the current levels of iron ore prices are insufficient for high-cost iron ore producers, particularly domestic Chinese iron ore miners. China is the world’s largest producer of iron ore. [9] Around 80% of Chinese domestic iron ore producers break even at prices levels of $80-90 per ton. [8] If prices remain at current levels for a long time, a significant proportion of these producers may be forced to cut back on production. Such a scenario would result in a more favorable global supply-demand equation which would boost iron ore prices.

If we assume that this scenario materializes and iron ore prices recover to around $80 per ton by 2017, it would significantly boost realized prices and margins for Rio’s iron ore mining operations, as compared to the assumptions currently factored into our stock price model for the company. In this scenario, we will assume that the company’s production and capital expenditure plans remain unchanged. This is a highly plausible assumption since the company is already significantly ramping up iron ore production capacity and additional capital expenditures are unlikely. However, whereas absolute capital expenditure will remain unchanged in the V-shaped recovery scenario, capital expenditure expressed as a percentage of EBITDA (as forecast in our model) will decline due to higher EBITDA generated by the company in the V-shaped recovery scenario. If we factor in higher realized prices and margins and the corresponding capital expenditure forecasts for Rio’s iron ore mining operations, our price estimate for the company increases by around 29% from $43.04 to $55.51. Thus, in the event of a sharp recovery in iron ore prices, an upward adjustment in valuation could potentially follow for Rio Tinto.

See our complete analysis for Rio Tinto in the scenario of a V-shaped recovery in iron ore prices

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Notes:
  1. Iron Ore Prices, Y Charts []
  2. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg []
  3. World Economic Outlook January 2015, IMF []
  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 Price Forecast Cut by Morgan Stanley on Supply, Bloomberg []
  7. Iron Ore Caps 2014 Loss as Morgan Stanley Says Worst Over, Bloomberg []
  8. Iron Ore Slump No Bar to Supply as China Mines Shut: Commodities, Bloomberg [] []
  9. Iron Ore Production, U.S. Geological Survey 2014 []