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Rio Tinto's problems start with iron ore

New chief executive Jakob Stausholm will have bumper 2020 earnings but will likely see iron ore earnings falling from 2021 onwards
December 29, 2020

Rio Tinto (RIO) will arrive in 2021 much as it arrived in 2020: with surging iron ore profits and plenty of cash to hand back to shareholders. Under the surface, there are a few key differences. 

For one, Jakob Stausholm will have moved into the chief executive role, in place of Jean-Sebastien Jacques. Investors also have a clearer picture of Rio’s mid-term priorities and challenges, given the new environment the major miner is facing in terms of native title in Australia, following its destruction of the Juukan Gorge rock shelters in May, which led to Mr Jacques’ departure. 

As in the oil and gas industry, miners will be intensifying focus on their carbon footprints in 2020. The key part of this is the supply chain emissions of products, or scope 3 emissions, so Rio is already ahead, having offloaded its coal business. Operationally, the miner is also doing well given its existing use of renewable energy. 

 

But investors are also pushing for companies’ portfolios to contribute to the broader energy transition. Glencore (GLEN), for example, is a leader in this, despite its coal operations, because of its copper, nickel and cobalt production. All are critical ingredients for electric vehicles and other forms of green technology. 

Rio has assets that will increase its exposure to the energy transition, including the troubled Oyu Tolgoi underground expansion, but will be reliant on iron ore for the vast majority of profits for some time. This is similar to BHP (BHP), while Anglo American (AAL) has more of a spread of metals and minerals (including coal). 

RBC Capital Markets analyst Tyler Broda said the internal pick for the new chief executive would help Rio to sharpen up its portfolio. 

“With the complex problem-set facing Rio from ESG, to structural concentration in a commodity with a mixed longer-term outlook, and perhaps, most importantly, the need for the company to restore its social licence in Australia, this continuity should help top management avoid a potentially strategically-costly leadership transition phase,” he said. 

 

Alongside the Australia challenges, Mr Stausholm will now have to deliver the difficult Oyu Tolgoi underground expansion, in which Rio has already invested over $10bn (£7.5bn).  

RBC Capital Markets forecasts the mine will make up 7 per cent Rio’s attributable cash profits in 2028, when it ramps up to 480,000 tonnes (t) of copper a year, and it will be the fourth-largest copper mine in the world. 

This month, the company released the new estimate of the project’s cost and timeline: $6.8bn, compared with the previous $5.3bn estimate. This re-evaluation, announced last year due to “difficult ground conditions”, was finalised at the same time that relations between Rio and minor shareholders in Oyu Tolgoi had fallen apart. 

The miner operates Oyu Tolgoi through its 50.8 per cent holding in Turquoise Hill (Can:TRQ), which owns 66 per cent of the copper project. Turquoise Hill has opened arbitration proceedings with Rio over the funding of the underground mine. 

A minority shareholder in Turquoise Hill, Pentwater Capital Management, also recently accused Rio of acting against it and other entities with exposure to Turquoise Hill by pushing for an equity raise to fund the Oyu Tolgoi overrun. In September, Turquoise Hill said that  it would need to raise between $1.7bn and $3.6bn. Its current market capitalisation is $2.4bn. In the update, Rio also said the Mongolian government had not yet signed off on the new feasibility study for the mine, adding to the uncertainty. 

As an early Christmas present, the Mongolian Tax Authority said the holding company running Oyu Tolgoi had underpaid taxes and flagged other transactions as failing “arm’s length” tests, violating transfer pricing rules.

 

Which red metal? 

Rio has long relied on its Pilbara assets to drive earnings. Although it started as a copper miner in Spain, the company has been in Western Australia since the 1960s. In the last decade, the iron ore division has provided between 40 per cent (2010) and 53 per cent of sales (2019) and between 58 per cent (2018) and 91 per cent (2013) of operating profits. And no other division gets close in terms of marginal profitability. 

But steel and iron ore won’t remain this strong forever. Macquarie Bank recently forecast that iron ore will go into “severe price decline” within two years, and puts the long-term price at $61 per tonne (t), a full $100/t less than the current spot price. 

 

Rio’s cash cost of $14/t means profit can still be made at $61/t, but with production of over 300mt a year this will make a sizeable difference to earnings levels. While Rio did not break down exactly how the iron ore price affected its 2019 underlying earnings, the miner said commodity prices, overall, provided an extra $4.4bn compared with 2018. This was in a year where copper and aluminium were weak and iron ore rose. Overall underlying earrings were $21.2bn, so the average selling price moving from $63/t to $86/t made a significant difference. 

Consensus estimates compiled by FactSet see iron ore cash profits peaking this year at $18bn before steadily falling to $10bn by 2024. Copper will grow in terms of cash profits during that time, according to analysts, but not enough to make up the deficit. Rio is also looking at spending increases through Oyu Tolgoi and other major projects such as the Koodaideri iron ore project and the extremely deep Resolution copper mine in the US. 

Rio is certainly turning the ship more towards copper, but when iron ore backs off it will find itself behind the other majors. Massive profits are coming for 2020, without question, but investors should also consider how this blue-chip company will fare in the next couple of years. Hold at 5,572p.

Last IC view: Hold, 5,649p, 17 Dec 2020