Mining Giants Realign Amid Global Malaise

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London-based Rio Tinto (NYSE: RIO) is aiming to cut up to $7 billion by 2014; meanwhile it will increase its production of copper, iron ore, and aluminum. The world’s second largest iron ore producer wants to increase output to 290 million tons/year, from 283 million tons announced earlier, which will further increase to 360 million tons/year by 2015. The company’s executives believe that aluminum and Australian coal will pose a significant challenge, and most of the cost cutting will happen in these two areas of their operations – coal and aluminum.

Rio Tinto's Australian rival BHP Billiton (NYSE: BHP) is taking similar cost cutting measures and delaying investments as the demand for commodities continues to fall in the near term. Australian coal has been particularly under pressure because the falling levels of demand coupled with a strong Australian dollar and rising labor costs having made many projects economically less viable. The U.S shale gas boom has also created oversupplies for natural gas, whose prices have plummeted, making it a cheaper alternative to coal, though much of the U.S. production cannot be exported at this point.  Coal prices have fallen dramatically this year.  The Market Vectors Coal ETF is off 26.6% this year, though the price has stabilized between $24 and $26 per share, indicating that the worst may be over.

Rio will continue to move ahead with its $21 billion Australian iron-ore project. The company’s primary iron-ore customer, China, has been slowing down, but the HSBC China PMI crossing the 50 point benchmark, indicating an expanding industrial production for the first time in a year, is a bullish sign. This, along with various forms of QE – infrastructure spending, OMO to unlock credit markets—lend credence to the thesis that commodity demand may be turning the corner. In fact, Rio’s iron-ore expansion plans are aimed at capitalizing on increasing demand specifically from China, which is expected to peak at 1 billion tons/year by 2030.

Rio is currently reviewing its Australian Gove bauxite - aluminum operations. The project could face delays or temporary suspension unless the company finds a cheaper source to fuel its facilities. BHP has already halted the operations on number of its coal mines such as the Gregory open-cut coal mine on which it was working in a joint venture with Japanese conglomerate Mitsubishi and the Red Hill coal mine project -- one of Australia’s biggest coal mines with an estimated annual output of 14 million tons.

Brazil’s Vale SA (NYSE: VALE) is also aiming to cut back spending and sell its poor performing assets. The work on Vale’s $5 billion African iron-ore mine has also been halted as it was declared “non-core.” Vale’s current strategy is aimed at increasing its market share in iron-ore -- by focusing on more productive assets -- which has diminished from about one-third of the world’s total production a decade ago to less than a quarter now, most of it being taken up by Australians.

Much of these moves are simply rearranging assets while governments and central banks try to reflate the bubbles, so for the medium term, the stories coming from the leading miners will focus on cost cutting measures and portfolio/production realignment. According to the Australian Bureau of Statistics, firms have cut back on their planned investments by $6 billion to $173 billion in the last three months. Vale has already made it clear that its investments will peak in the current year and will be lower from here onwards.

However, Rio is hoping that its increase in production levels coupled with its massive infrastructure spending will give it a cost advantage over its competitors. On a positive note, its Pilbara’s project in Western Australia has been going according to plan with no substantial increase in cost projections. These developments will go a long way in generating revenues from China. The business’s current cost per ton for iron ore exported to China is around $47, which is going to fall once the development work is complete. Rio won’t be expanding in new large projects at the moment and would instead return some of the cash to the shareholders.

<table> <tbody> <tr> <td> </td> <td> <p><strong>Rio Tinto</strong></p> </td> <td> <p><strong>Vale</strong></p> </td> <td> <p><strong>BHP</strong></p> </td> </tr> <tr> <td> <p><strong>Stock YTD</strong></p> </td> <td> <p><strong>+3.75%</strong></p> </td> <td> <p><strong>-17%</strong></p> </td> <td> <p><strong>+2.91%</strong></p> </td> </tr> <tr> <td> <p><strong>P/E</strong></p> </td> <td> <p>22.78</p> </td> <td> <p>7.66</p> </td> <td> <p>12.49</p> </td> </tr> <tr> <td> <p><strong>EPS</strong></p> </td> <td> <p>2.19</p> </td> <td> <p>2.28</p> </td> <td> <p>5.77</p> </td> </tr> <tr> <td> <p><strong>Yield</strong></p> </td> <td> <p>2.90%</p> </td> <td> <p>3.60%</p> </td> <td> <p>3.20%</p> </td> </tr> <tr> <td> <p><strong>ROA</strong></p> </td> <td> <p>9.30%</p> </td> <td> <p>8.58%</p> </td> <td> <p>14.21%</p> </td> </tr> <tr> <td> <p><strong>ROE</strong></p> </td> <td> <p>7.12%</p> </td> <td> <p>14.73%</p> </td> <td> <p>24.88%</p> </td> </tr> </tbody> </table>

Naturally, with cost cutting there are going to be layoffs as well, but the exact total is not yet known. Iron ore prices have risen in October to $113.95 MT after bottoming in September 2012 to $99.47 MT, but Australian thermal coal price of $88.29 MT is at the lowest level this year.  One of the benefits of this drop in both iron and coal prices is the positive effect it will have on the economies of Southeast Asia, like Malaysia, Thailand and Indonesia, who are all moving towards using more coal to generating electricity.  PTT in Thailand has been actively securing more coal resources, for example.  With the amount of infrastructure to be built around the region -- road, rail, port upgrades, power plants, etc – that ASEAN is building in preparation for the AEC in 2015 this crash in prices is a boon to local investment projects. 

While this is good news for ETF’s like the iShares MCSI Malaysia ETF and the Global X ASEAN ETF, it is not for the mining companies this article covers.  While the long-term fundamentals for commodities like iron and coal are still strong, the deflationary wave we’re working through now will require time to complete, and these companies will likely have brighter futures in 2014 and beyond. 


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