Rio Tinto 1H 2015 Earnings Review: Rising Production Levels Despite Weak Iron Ore Prices

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Rio Tinto (NYSE:RIO) released its earnings results for the first half of 2015 and conducted a conference call with analysts on August 6. [1] As expected, the sharp decline in iron ore prices over the last twelve months negatively impacted the company’s first half results, with the increase in iron ore production and the company’s cost reduction initiatives offsetting some of the impact of the decline in iron ore prices. Rio’s EBITDA margin declined to 38% in the first half of 2015, as compared to 41% in the corresponding period of last year. [2] The decline in margins was significantly lesser than the 46% year-over-year decline in iron ore prices. [2] The key takeaway from Rio’s earnings release was the company’s continued emphasis on raising production levels, despite the sharp decline in iron ore prices. The company’s low-cost iron ore deposits enable it to produce profitably even at current price levels.

Fall in Iron Ore Prices

Iron ore prices have declined substantially over the course of the last twelve months, as illustrated in the chart shown below.

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Iron Ore Prices, Y Charts

 

Iron ore prices have weakened considerably over the last twelve months as a result of oversupplied global markets. 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.

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.

Rising Production

Despite the fall in iron ore prices over the past year, Rio Tinto has continued to raise iron ore production. 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. Though some high-cost iron ore supply has exited the market, the increase in production by iron ore majors has more than made up for it, particularly given the subdued demand conditions for iron ore. As a result, iron ore prices have remained fairly subdued. Rio Tinto, with its low-cost iron ore deposits, can continue to operate profitably in the prevailing iron ore pricing environment. In fact, the company can continue to operate profitably even if iron ore prices fall to $50 per ton. [7] Economies of scale and the company’s cost reduction initiatives have ensured that Rio Tinto continues to operate profitably even in the current iron ore pricing environment.

In keeping with Rio Tinto’s high production volumes strategy, 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. [8] 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) in 2014 at Rio’s Pilbara operations, which account for more than 90% of the company’s iron ore production. [9] The expansion of infrastructure to support production rates of 360 Mt/a was completed in 2015, which would enable a further increase in production over the next few years. [2] As a result of Rio’s high volumes strategy, unit cash production costs at the Pilbara operations declined to $16.20 per ton in the 1H 2015, which is around 21% lower on a year-over-year basis. [10] Cost reductions, favorable exchange rate variations, and lower energy costs, have offset nearly 40% of the impact of the decline in iron ore prices on the company’s 1H 2015 results. [11]

Thus, Rio Tinto intends to raise its iron ore output despite the weakness in prices. The success of this strategy is contingent upon sufficient quantities of high-cost iron ore supply exiting the market so that iron ore prices rise substantially. It remains to be seen whether such a scenario actually materializes. Though Rio Tinto can continue to operate profitably at current price levels, the company’s profitability is unlikely to rise significantly, should prices not increase appreciably.

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Notes:
  1. Half year results 2015 Webcast, Rio Tinto Website []
  2. Rio Tinto’s H1 2015 Earnings Results, SEC [] [] []
  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. BHP, Rio Gamble With A Stacked Iron Ore Deck, Mineweb []
  8. Rio Tinto’s Q2 2015 Operations Review, Rio Tinto Website []
  9. Rio Tinto announces landmark Pilbara iron ore operational performance ahead of schedule, Rio Tinto Media Release []
  10. Rio Tinto’s H1 2015 Earnings Presentation, Rio Tinto Website []
  11. Rio Tinto’s 1H 2015 Earnings Conference Call Transcript, Rio Tinto Website []