Rio Tinto’s Plans To Develop Amrun Bauxite Project: A Gamble On Strength Of Aluminum Pricing?

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Rio Tinto (NYSE:RIO) has announced plans to go ahead with the development of its $1.9 billion Amrun bauxite mining project, a move that is at odds with the company’s recent steps to reduce capital spending. [1] Rio Tinto has reduced its capital spending in response to the downturn in commodity prices over the course of the last couple of years, in order to conserve cash during a low point in the commodity cycle. Rio Tinto expects overall capital spending for 2015 to stand at $5.5 billion, which is sharply lower as compared to capital expenditure of $13 billion in 2013. [2] The Amrun bauxite mine is expected to commence production in 2019. [1] Bauxite is the raw material for the production of alumina, and alumina is primarily used in the production of aluminum. Rio Tinto’s aluminum sales are mainly sold in Asian markets, particularly China. With the announcement of the development of the Amrun project, Rio Tinto is betting on a recovery in aluminum prices over the next few years.

A Gamble on the Strength of Aluminum Pricing ?

Aluminum is a metal that is extensively used in industrial applications. It is an important input in the aerospace, automotive, construction, commercial transportation, packaging, power generation, capital goods, and consumer durables industries. Given the diverse scope of application of aluminum in industry, demand for the metal is often broadly considered a proxy for industrial growth, and by extension for economic growth. China is the world’s largest consumer of aluminum, accounting for nearly half the world’s consumption of the metal. [3] Weakening economic growth in China, which stood at 9.5% in 2011 and is expected to decline to 6.3% in 2016, and economic weakness in Europe, has dampened global demand for aluminum. [4]

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Despite subdued demand conditions resulting from weakening economic conditions, global aluminum supply has not been rationalized in response to the weakness in demand over the past few years, as a result of burgeoning Chinese aluminum production. The impact of smelting capacity reductions by global aluminum majors, like Alcoa and Rusal, was nullified by additions to smelting capacity by Chinese companies. Since China accounts for nearly half of the world’s aluminum production, the expansion in production by Chinese producers more than made up for capacity cuts by global majors. [5] State support, in the form of tax breaks, subsidies, and the supply of electricity at concessional rates to smelters, allowed Chinese producers to increase production levels despite weakness in demand and pricing. With weak domestic demand persisting in China, aluminum exports from the country have risen, worsening the global oversupply of aluminum, and keeping prices subdued. Chinese exports rose 22% year-over-year in the first eight months of 2015. [6]

LME Aluminum Prices in 2015, Source: LME

Thus, given the prevailing demand side weakness, current market conditions are certainly not conducive for an expansion in Rio’s bauxite output. But will conditions have improved sufficiently by 2019, when production from the Amrun mine is expected to commence? It is not a simple question to answer. Chinese production and demand for aluminum will continue to remain the most important factor influencing the global balance of aluminum demand and supply for the foreseeable future. Though China continues to be characterized by long-term trends in industrialization and urbanization, whether the country will be able to sustain comparable growth rates in both GDP and aluminum demand is a big question mark. Increasingly stringent automobile emissions regulations in the U.S. and Europe are driving increasing adoption of aluminum in the automotive sector. Should similar regulations be enacted in China, these could trigger increasing long-term demand for aluminum in China. However, the pace of growth in Chinese aluminum demand in the near future remains uncertain.

Global aluminum supply may have to be rationalized to adjust to lower growth in aluminum demand, in order to allow prices of the metal to rise. The most prominent stumbling block for such a downward adjustment in aluminum supply is Chinese state support to its domestic smelting industry. State intervention in the form of subsidies and tax breaks continues to provide skewed incentives to Chinese smelters to maintain high levels of production irrespective of the level of prices. Should China continue to churn out record levels of aluminum production and exports, without a substantial increase in demand, aluminum prices are unlikely to rise significantly. Thus, the success of Rio Tinto’s plans to develop the Amrun bauxite mine would depend on a number of factors which are beyond its control. It remains to be seen whether the company’s optimism proves to be well-founded.

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Notes:
  1. Rio Tinto approves US$1.9 billion Amrun (South of Embley) bauxite project, Rio Tinto News Release [] []
  2. Rio Tinto’s 2014 20-F, SEC []
  3. Aluminum Consumption By Region, Rusal Website []
  4. World Economic Outlook, IMF []
  5. Global aluminum production; the sound of one hand clapping, Reuters []
  6. Aluminum Exports From China Slide to 14-Month Low as Prices Drop, Bloomberg []