A Scenario That Could Negatively Impact Rio Tinto’s Stock Price

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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 $58 per dry metric ton (dmt) at the end of March, around 48% 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.

Rio’s iron ore shipments are expected to grow fairly robustly over the next few years, in line with its plans to ramp up production from its expanded Pilbara iron ore mining operations in Western Australia. The company is betting on the robustness of Chinese demand for the commodity to drive its iron ore sales. However, the company’s fortunes are to a large extent tied to the sustainability of Chinese demand for its iron ore sales. If economic growth in China takes longer than expected to recover, there is a possibility that the company would be unable to sell its envisioned levels of iron ore shipments, which would negatively impact its prospects. In this article, we will explore the impact of this scenario on the company’s stock price.

See our complete analysis for Rio Tinto

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Impact of Persistently Weak Iron Ore Demand Scenario on Rio

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. China is the world’s largest producer of iron ore. [6] Around 80% of Chinese domestic iron ore producers break even at price levels of $80-90 per ton. [7] If prices remain at current levels for a long time, a significant proportion of these producers may be forced to cut back on production.

However, if demand for iron ore in China does not rebound significantly over the next few years, or if Rio is unable to displace sufficient quantities of high-cost domestic Chinese iron ore production, it could take a toll on the company’s prospects. As per projections by major Wall Street banks, the worldwide surplus of seaborne iron ore supply could 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. [8] [9]

If we assume that this scenario materializes, we would have to revise down our iron ore shipment forecasts for the company. In addition, lower shipments would also negatively impact margins. In this scenario, we will assume that the company’s production and capital expenditure plans remain unchanged. However, whereas absolute capital expenditure will remain unchanged, capital expenditure expressed as a percentage of EBITDA (as forecast in our model) will increase due to lower EBITDA generated by the company in the weak demand scenario. If we factor in lower shipments and margins and the corresponding capital expenditure forecasts for Rio’s iron ore mining operations, our price estimate for the company decreases by around 22% from $43.04 to $33.73. Thus, in the event of persisting weakness in iron ore demand, a downward adjustment in valuation could potentially follow for Rio.

See our complete analysis for Rio in the Persistently Weak Iron Ore Demand scenario

 

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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 Production, U.S. Geological Survey 2014 []
  7. Iron Ore Slump No Bar to Supply as China Mines Shut: Commodities, Bloomberg []
  8. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg []
  9. Iron Ore Caps 2014 Loss as Morgan Stanley Says Worst Over, Bloomberg []