Rio’s Results Will Show The Challenging Macro Conditions

Rio Tinto (NYSE:RIO), the world’s second largest iron ore producer, will release its half-yearly earnings on Wednesday. We expect the company to report a fall in profits, in line with the trend observed among other mining companies like BHP Billiton and Vale (NYSE:VALE). We expect lower realized prices and rising costs to significantly weigh on revenue and operating income. Rio Tinto itself has said that it now expects its production of copper, coking coal and thermal coal to fall short of its April forecast, with output of alumina and aluminium modestly higher. It, however, maintained its production forecast figures for iron ore, its main earnings driver. It has said that the multi-billion dollar expansion of its Western Australia operations to 353 million tons a year by mid-2015 remains on track. ((Rio Tinto Trims Production Forecasts, 7 August 2012, WSJ))

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Labor, Capital Equipment, LNG Costs Rise…

A rise in labor and capital equipment costs have resulted in high operating costs for Rio Tinto, according to its own yearly outlook. ^[1] The situation hasn’t improved since then because inflation prompted by the rapid expansion of the mining industry typically lags commodity price fall by 12 to 15 months. Labor costs have been rising in response to significant investment growth across the mining, oil and gas, and infrastructure sectors.  Many countries are seeing shortfalls in available labor and as a result, continued growth in real mining wages is being recorded. Construction laborers, skilled engineers, project managers, and contractors are all in short supply. To meet the shortfall, some labor would have to move across from other sectors or would need to be recruited from elsewhere in the world and housed in places where the mines are located. This, naturally, would place upward pressure on wages and operating costs.

The increased demand for construction, mining and agricultural machinery has increased demand for tires. Primary producers have aggressively built capacity to meet demand. Costs per tire have increased on the back of increased demand and high prices of rubber whose production was impacted by heavy floods in Thailand. The high prices for heavy machinery like trucks and excavators haven’t helped either.

Rio Tinto has also recently admitted that LNG shortages have started becoming an issue because producers are preferring to export it, lured by high spot prices in international markets.

…While Bleak Near Term Economic Outlook Doesn’t Help Either

The single biggest threat at this point remains the risk of contagion from Eurozone’s fiscal woes. Is is expected to impact China the most, if it happens. Since China is by far the largest consumer of resources, its economic  fortunes have a disproportionate impact on those of mining companies. Another somewhat correlated matter of concern would be a a disorderly and sharper than expected housing market downturn in China. The real estate sector in that country has been in a bubble for quite sometime now and could nosedive if the economic sentiment turns overwhelmingly adverse. Demand for steel and therefore iron ore,which constitutes Rio’s largest business, would be severely impacted.

The weak economic sentiment in US, Europe and China has resulted in prices tumbling across the board for metals like nickel, copper and iron ore in the last few months. Low prices will directly impact Rio’s top-line figures, and combined with rising costs affect the bottom-line.

Over the next decade, however, we believe that average commodity prices will be higher than those in the past. Periodic bouts of volatility may persist but nonetheless, growth is expected to be high on the whole. The population in emerging markets remains aspirational and there is significant room for growth, given the low starting base in many of these places.

We shall be revising our estimates after Rio comes out with its earnings numbers.

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1. Outlook for Metals and Minerals, Rio Tinto [↩]