With the first ore shipped from its latest $US12 billion expansion of its Pilbara iron ore production base to 290 million tonnes a year Rio Tinto appears increasingly optimistic about the prospects for lifting output to 360 million tonnes a year.
The prospect of Rio ploughing another $US5 billion or so into the Pilbara may not please those who have been urging Rio Tinto and its peers to stop investing and instead hand surplus cash back to shareholders but the presentation Rio made to analysts today makes the case for continuing to ramp up its iron ore output.
It helps Rio’s case that the analysts tour of its West Australian operations has coincided with positive news out of China, with HSBC’s manufacturing purchasing managers' index back in positive territory, suggesting growth in its manufacturing sector has re-started.
China’s authorities last week said the economy was on track to meet their target for GDP growth of 7.5 per cent this year which, if achieved, would mean a soft landing for the economy amid concerns that it would post significantly lower growth.
The issue of continuing investment in iron ore isn’t, of course, just about near term conditions in China but about the longer term outlook for supply and demand.
There is a view that the market for iron ore could be in surplus as early as next year as the massive investment by producers in expanding production in recent years expands supply even as the growth rate in demand is tapering. Goldman Sachs analysts have forecast a surplus of supply over demand of about 200 million tonnes by 2015.
Rio, which essentially generates its entire profitability from its iron ore business, believes that the long-term fundamentals for iron ore demand from China remain strong, with its demand, after accounting for its recycling of scrap metal, not peaking until after 2030.
The core of the case for continuing expansion of Rio’s WA operations is that Rio is the industry’s low-cost producer and its ores are among the highest quality in the sector.
If there is to be a surplus of supply in the next few years it ought to be the higher-cost, lower-quality production that gets displaced first.
Rio made the point today that Chinese domestic iron ore production (which is high-cost) has reacted quickly and rationally to prices changes in the past. It says China’s domestic industry’s costs will continue to increase strongly as a result of its appreciating currency, a shift to underground mining and rising input costs.
The next phase of Rio’s expansion, to 360 million tonnes, would cost more than $US5 billion but the group does have options for pursuing that extra output. It says there are low-cost incremental and brownfields options as well as greenfields opportunities and has highlighted that its expansions to date have had relatively low capital intensity and have been delivered on-budget and ahead of schedule.
It is already the low-cost operator but, along with all the big miners, Rio is focusing intensely on lowering costs that were pushed up during the boom years. It says that in 2012 its cash costs were $US23.50 a tonne but in the first half of this year it had reduced them to $US23.1 a tonne through reduced spending on contractors and consultants and that it expects to lower them further in future.
It also sees supply constraints, contrasting the announced increases in supply with the actual increase in production from completed projects. Reduced sources of project funding, protracted approvals processes and lower quality resources would, now that peak iron prices are well behind the sector, have an impact on future supply.
Rio didn’t refer to (but could have) its own difficulties in bringing the giant Simandou project in Guinea on stream. Last week Rio, its partner Chalco, the World Bank had Guinea signed a draft agreement that deferred a first-production target from 2015 to 2018. BHP has already shelved its proposed $US20 billion Outer Harbour expansion at Port Hedland.
The pipeline of future new supply is shrinking and, to the extent that Rio can deliver incremental increase in its production with relatively low capital intensity while retaining its lowest-cost producer status, it will push uncompetitive tonnes out of the market and that potential extra supply further out into the future.