Will Rio be Grande?

The stock in focus this month is Rio Tinto (RIO). In investment circles, as soon as analyst and market participants start saying, “This time it’s different”, it is usually an excellent signal to be doing the exact opposite of what everyone else is doing. The last 10 years in the corporate life of Rio Tinto is an instructive example of this premise, as it is often particularly apt to cyclical industries.

Rio is one of the world’s largest mining conglomerates with interests in aluminium, borax, coal, copper, gold, titanium and zircon and their largest business, iron ore. The commodities sector is dominated by the principles of supply and demand. When demand is high and supply is tight, prices in commodities such as iron ore will rise, and very simply, profits for miners of these commodities will accelerate. However, as prices rise, marginal producers are attracted to start or increase production, increasing supply, which will have a negative impact on pricing. When increased supply intersects with a drop off in demand, this can be quite dramatic.

This is exactly what happened back in 2008-2010. With the Chinese economic expansion in full swing and recent investment in iron ore low, prices shot up dramatically. This resulted in a rocketing share price for Rio, and led to many commentators talking about a commodities super cycle that would last forever, and a structural change in how commodities are priced – “This time it’s different”.

However, it was not different, and as Rio and other producers ramped up production and hence supply, Chinese growth moderated, leading to a steep crash in prices for the commodity and the share price. Completely without shame, analysts and market commentators began talking about prices being “lower for longer” and a permanent over supply of an abundant commodity – “This time it’s different”.

Of course, they were wrong again, uneconomic production has been curtailed, demand has picked up and we have seen prices recover quite strongly over the past 12 months. Following a series of poorly timed investments, Rio management was refreshed and current management has done an excellent job lowering costs and increasing efficiencies, with a focus on free cash flow production.

The dearth of investment in capacity in recent years means we will probably see an extended period of tighter supply (you cannot switch on a huge mining operation like turning on a tap) and if demand stays robust, this will lead to higher prices being maintained. However, we will be vigilant when the call comes from analysts that Rio needs to be re-rated because we are in the next commodities supercycle, and that “This time it’s different”.

Quick Stats:

  • In 2016, Rio produced 327.6 million tonnes of iron ore in the Pilbara
  • Rio recently agreed to sell its Australian coal business to Yancoal for $2.45 bln
  • Rio is a leader in technology, with its Autohaul project looking to change how mines operate

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