Rio Tinto’s Full Year 2015 Earnings Preview: Weak Commodity Prices To Weigh On Results

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Rio Tinto (NYSE:RIO) will release its results for the full year 2015 and conduct a conference call with analysts on Thursday, February 11. [1] We expect the sharp decline in commodity prices in 2015, particularly iron ore prices, to adversely affect the results of Rio Tinto, a diversified mining company and the world’s second largest iron ore producer. However, a combination of a sharp increase in production volumes, particularly those of iron ore, and the company’s cost reduction efforts will mitigate the negative impact of weaker commodity prices on Rio Tinto’s results. The company announces its earnings results semi-annually. During the first half of 2015, the company’s EBITDA margin fell by only 300 basis points to 38% despite a steep 46% year-over-year decline in iron ore prices. [2] In this article, we will take a look at what to expect from Rio Tinto’s full year 2015 results.

Weak Commodity Prices

Weakness in the prices of all commodities produced by Rio Tinto will negatively impact the company’s full year results. The price of iron ore, the sale of which accounts for nearly half of the company’s revenue, has fallen sharply over the course of the last twelve months, as illustrated by the chart shown below.

Iron Ore Prices, Source: Y Charts

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Iron ore prices have declined due to the prevailing oversupply situation, resulting from a combination of demand-side weakness and elevated production levels. Weakening Chinese economic growth has translated into weak demand for iron ore, since China is the world’s largest consumer of the commodity. The Chinese steel industry accounts for the purchase of approximately two-thirds of the world’s seaborne iron ore supply. [3] Since iron ore is used as a raw material in the production of steel, the demand for steel is a good indicator of the underlying demand for iron ore. As per World Steel Association estimates, the demand for steel in China is set to contract for the third consecutive year in 2016. [4] Given the subdued demand conditions, rising production from iron ore majors such as Vale, Rio Tinto, and BHP Billiton has boosted global supply, resulting in an oversupply situation. Given the prevailing weakness in iron ore prices, the closure of high-cost iron ore production capacity has lessened the extent of the oversupply. However, the oversupply situation is expected to prevail over the next couple of years, with the surplus of seaborne iron ore supply expected to rise to 97 million tons by 2018 from an expected surplus of 65 million tons in 2016. [5] The persisting oversupply situation has translated into a weakness in iron ore prices, which will negatively impact Rio Tinto’s results.

Besides impacting iron ores prices, demand-side weakness as a result of slowing Chinese economic growth, has also negatively impacted the prices of some of the other major commodities produced by Rio Tinto, such as copper and aluminum. LME aluminum prices stood roughly 15% lower year-over-year in 2015, whereas the following graph illustrates the decline in copper prices in 2015. [6] The subdued commodity pricing environment will certainly negatively impact Rio Tinto’s 2015 results.

Copper Prices in 2015, Source: LME

Production Review

The company has already released its production data for the full year 2015. Consolidated iron ore production at Rio’s facilities stood at 327.6 million tons in 2015, which was 11% higher year-over-year. [7] The sharp increase in volumes was primarily due to the ramp-up of production to a rate of 330 million tons per year (Mt/a) at Rio’s Pilbara operations in 2015. [8] The Pilbara iron ore mines in Western Australia represent roughly 95% of Rio Tinto’s global iron ore production. [7] The sharp increase in iron ore production volumes will help lower average production costs at the Pilbara mines, propping up margins.

Besides higher iron ore production, increased production from the Kestrel, Hunter Valley, and Hail Creek mines translated into an 11% year-over-year increase in Rio Tinto’s coal production. [7]  However, subdued coal prices will adversely impact the company’s results.

Cost Reduction Initiatives

With the company nearly achieving its planned cost reduction target for 2015 in the first half of the year, it increased its cash cost reduction target to $1 billion for the year. ((Rio Tinto H1 2015 Earnings Presentation, Rio Tinto Website)) A reduction in operating costs will help mitigate the impact of top line headwinds on the company’s results and prop up its bottom line. [9] In addition, Rio Tinto has managed to reduce capital spending by nearly one-third in 2015. [9]

With intense top line headwinds expected to weigh on Rio Tinto’s full year results, we expect the company’s margins to deteriorate. However, the company’s cost reduction initiatives will mitigate the impact of subdued commodity prices on its results. Given that the ongoing downturn in iron ore prices is unlikely to end soon, these cost reduction initiatives will stand the company in good stead going forward.

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Notes:
  1. Rio Tinto Annual Results 2015, 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. Iron Ore Outlook Cut by Morgan Stanley as Supply Floods Market, Bloomberg []
  6. LME Aluminum Prices, Source: LME []
  7. Fourth Quarter 2015 Operations Review, Rio Tinto Media Release [] [] []
  8. Rio Tinto announces landmark Pilbara iron ore operational performance ahead of schedule, Rio Tinto Media Release []
  9. Rio Tinto H1 2015 Earnings Presentation, Rio Tinto Website [] []