Cost Reduction The Way Forward For Rio Tinto In Subdued Commodity Pricing Environment

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Rio Tinto (NYSE:RIO) has announced more plans for cost reduction and productivity improvements, as it grapples with a weak commodity pricing environment, impacting all the commodities that it produces. The company announced that its Aluminum product group will realize $300 million worth of cash cost reductions in 2015, with a similar target for cash cost reductions planned for next year. [1] The announcement mirrors a wave of similar moves by companies across the metals and mining space in response to the downturn in commodity prices. Rio’s focus on cost reduction is certainly the need of the hour, and the latest announcements will help the company shore up its cash flows in the near term, as it looks to ride out the ongoing downturn in commodity prices.

Weakness in Commodity Prices

Aluminum Prices, Source: LME

The chart shown above illustrates the sharp decline in aluminum prices over the past twelve months. The decline in prices has largely been an outcome of an oversupply situation resulting from a combination of an economic slowdown in China and elevated levels of production in the country, which is the world’s largest producer, as well as consumer, of the metal. [2] Chinese economic growth is expected to slump to 6.3% in 2016, from 6.8% and 7.4%, in 2015 and 2014, respectively. [3] As aluminum is a metal that has extensive industrial applications, weakening economic growth is a dampener for growth in aluminum demand.

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On the supply side, elevated levels of Chinese production have offset the impact of the shutdown of high-cost production capacity by global aluminum majors such as Alcoa and Rusal. [4] State support in the form of  subsides, tax breaks, and the provision of cheap electricity has enabled Chinese producers to increase production levels despite the ongoing weakness in demand and pricing. As domestic aluminum demand remains weak, with rising production Chinese aluminum exports have risen, worsening the global oversupply of aluminum and keeping prices subdued.

With Chinese economic growth expected to slow further in 2015, aluminum prices are unlikely to increase significantly in the near term. Expectations of weak pricing in the near term have prompted miners to focus upon cost reduction. With both iron ore and copper, the other major commodities that Rio Tinto produces, also in the middle of an extended period of weakness in prices, cost reduction across all of the company’s mining operations has become imperative.

Iron Ore Prices, Source: Y Charts

Given the need for cutting costs across all mining operations, Rio has lowered its planned capital spending for 2016 to $5 billion, as compared to previous estimates of $6 billion. [1] Announcements of reduction in capital spending have been a recurring theme across mining companies lately. Vale, amongst Rio’s biggest competitors, announced plans to cut capital spending across a range of mining operations earlier in the month. [5] Other major mining companies such as Freeport-McMoRan have also made recent announcements pertaining to rationalization of capital spending. [6] Given that the depressed commodity pricing environment is likely to persist in the near term, spending cuts are necessary to protect miners’ cash flows. Rio’s latest move will certainly stand it in good stead over the next couple of years.

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Notes:
  1. Rio Tinto delivers productivity gains and cost savings in Aluminium and provides update on Group capital expenditure, Rio Tinto News Release [] []
  2. Aluminum Consumption By Region, Rusal Website []
  3. World Economic Outlook, IMF []
  4. Global aluminum production; the sound of one hand clapping, Reuters []
  5. Cost reduction and focus on project delivery: highlights of Vale Day NY, Vale News Release []
  6. Freeport-McMoRan Announces Further Reduction in Capital Spending, Metals Production & Suspension of Common Stock Dividend, Freeport-McMoRan Inc. News Release []