Rio Tinto’s First Half 2015 Earnings Preview: Strong 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 earnings results for the first half of 2015 and conduct a conference call with analysts on August 6. [1] We expect a sharp drop in commodity prices over the last twelve months, particularly iron ore prices, to negatively impact the results of Rio Tinto, a diversified mining company and the world’s second largest iron ore producer. 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. In Rio’s previous results announcement for the full year 2014, the company’s EBITDA margin held steady at 39% despite weak commodity prices, with higher production volumes and the company’s cost reduction initiatives offsetting the impact of weak commodity prices on the company’s results. [2] In this article, we will take a look at what to expect from the company’s results for the first half of 2015.

Commodity Prices

Iron ore is primarily used as a raw material for the production of steel. Thus, demand for iron ore by the steel industry plays a major role in determining its prices. Benchmark international iron ore prices are heavily influenced by Chinese demand, since Chinese steel mills purchase nearly two-thirds of the world’s seaborne iron ore supply. [3] Chinese steel demand growth is expected to decline by 0.5% in 2015, following on from a 3.3% decline in 2014. [4] 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. [5] The worldwide surplus of seaborne iron ore supply is expected to rise to 437 million tons in 2018, from an expected surplus of 184 million tons in 2015. [6] A combination of weak demand and oversupply is likely to result in weak iron ore prices in the near term. The following chart illustrates the trajectory of iron ore prices over the last twelve months.

Iron Ore Prices, Source: Y Charts

Among other major commodities sold by Rio Tinto, copper is also characterized by weak demand and pricing environments. The weakness in demand for copper is mainly due to subdued demand from China, which accounts for nearly 40% of the global demand for the metal. [7]. A slowing Chinese economy has dampened Chinese demand for the metal. Chinese GDP growth is expected to slow to 6.8% in 2015, from 7.4% in 2014. [8] The following chart illustrates the trajectory of copper prices over the last twelve months.

Copper Prices, Source: LME

Thus, a weak commodity pricing environment is expected to negatively impact Rio Tinto’s results for the first half of 2015.

Production Review

Rio Tinto has already released its production data for the first half of 2015. Consolidated iron ore production at Rio’s facilities stood at 154.3 million tons in the first half of 2015, which was 11% higher year-over-year. ((Rio Tinto’s Q2 2015 Operations Review, Rio Tinto Website)) 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 2014. [9] Located in Western Australia, the Pilbara iron ore mines represent over 90% of Rio’s global iron ore production. [10]

Rio Tinto has continued to raise iron ore production despite the prevailing oversupply situation in global iron ore markets. The world’s biggest iron ore producers, including Rio Tinto, have been banking upon the displacement of sufficient quantities of high-cost iron ore supply from other producers by low-cost iron ore production from their own mines, resulting in a more favorable demand-supply equation. However, this scenario has not yet materialized, with oversupplied global markets keeping prices weak. Rio Tinto, with its low-cost iron ore deposits, can continue to operate profitably in the prevailing iron ore pricing environment. The company can, in fact, continue to operate profitably even if iron ore prices fall to $50 per ton. [11] Economies of scale and the company’s cost reduction initiatives have ensured that the company continues to operate profitably even in the current adverse pricing environment.

Cost Reduction

In addition to expanding iron ore production capacity, cost reduction initiatives are an important component of the company’s strategy to operate in a subdued commodity pricing environment. Rio Tinto achieved $4.8 billion in savings pertaining to operating, exploration, and evaluation costs in 2014, as compared to its 2012 spending. [12] The company also lowered its capital expenditure by nearly $9.4 billion from 2012 levels, to $8.2 billion in 2014. [12] These efforts will further enhance the company’s flexibility to operate in the prevailing commodity pricing environment.

Thus, we expect Rio’s first half results to be negatively impacted by the sharp 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 2015 Webcast, Rio Tinto Website []
  2. Rio Tinto’s Full Year 2014 Results Media Release, Rio Tinto Website []
  3. China Plans Iron Ore Subsidy for Miners Amid Rout, News Says, Bloomberg []
  4. Short Range Outlook 2015-2016, World Steel Association []
  5. BHP, Rio Gamble with Stacked Iron Ore Deck, Mineweb []
  6. Iron Ore Majors Boosting Supply as Glut, China Sink Prices, Bloomberg []
  7. Copper Ends at 5-Month Low on China Worries, Wall Street Journal []
  8. World Economic Outlook, IMF []
  9. Rio Tinto announces landmark Pilbara iron ore operational performance ahead of schedule, Rio Tinto Media Release []
  10. Rio Tinto’s 2013 20-F, SEC []
  11. BHP, Rio Gamble With A Stacked Iron Ore Deck, Mineweb []
  12. Generating Value Through The Cycle, Rio Tinto Presentation [] []