Rio Tinto's secret growth option

One down. One up. It's not quite as simple as that but as shareholders in Rio Tinto consider last night's fall in the iron ore price to a 10-year low they might also consider the rise of bauxite, the ore of aluminium, to a multi-year high.

Forever the bridesmaid in the portfolio of Australia's biggest iron ore miner, bauxite is emerging as an asset which will fill part of the hole in Rio Tinto's earnings from the iron ore collapse.

It is unlikely that bauxite will ever rival iron ore as a profit earner for the diversified miner, though stranger things have happened, and even iron ore was once a small business unit inside Rio Tinto.

The best way to see bauxite is as an unexpected growth option with rising profit potential at a time when most other assets in Rio Tinto's portfolio are not growing, or have reached their limit of growth in the current cycle of commodity prices.

One of the best ways to compare what's happening in iron ore and bauxite is the price of the commodities.

Two years ago a tonne of iron ore sold for around $US150, and a tonne of bauxite fetched around $US45. Last night iron ore was selling for $US51.35/t while of bauxite is selling for around $55/t.

There are variations in the prices of both ores to allow for differences in quality, and Rio Tinto produces far more iron ore than bauxite, but the essential message is that a tonne of bauxite today is worth roughly the same as a tonne of iron ore (or perhaps a bit more).

The rising importance of bauxite to Rio Tinto can be traced to three recent developments, one of which is a subtle change in the way the company reports its financial performance.

In the latest annual report, for the first time, bauxite profits have been broken out as a separate line item, an interesting pointer to what is expected to be the start of a major expansion of the industry later this year.

Compared with iron ore's overall profit contribution (Australia and Canada) of $US8.1 billion, bauxite's contribution of $429 million was small beer, though those numbers mask the fact that the bauxite profit represented a rise of 14%, whereas iron ore profits fell by 17%.

The second development is that the board of Rio Tinto is close to committing around $US1.5 billion to a new bauxite mine called South of Embley which, as the name implies is a project south of the Embley River on Queensland's Cape York peninsula, the centre of Rio Tinto's bauxite operations near the town of Weipa.

The third development is more of an observation about the very long term interests of the company which can be detected in where it is spending exploration dollars.

According to the exploration sector in the annual report there are six projects described as being “at a more advanced stage”, with two of the six involving bauxite discoveries (one in Laos and one in Brazil) followed by projects looking for nickel, uranium, coking coal and iron ore.

Exploration is the research and development arm of all mining companies and that fact that one-third of Rio Tinto's “advanced” exploration projects are bauxite-linked is an interesting view of the company's potential future.

The key to Rio Tinto's revived interest in bauxite is a mismatch in the structure of the world's aluminium industry, a business which is divided into three stages – bauxite mining (the ore), alumina refining (first stage processing) and aluminium smelting (metal production).

Over the past decade there has been heavy investment in the two processing stages of aluminium in countries which use a lot of the metal, especially China, and in countries with surplus energy which, in the case of Saudi Arabia, means using gas which would once have been wasted in an oilfield flare to generate the electricity which is used to produce aluminium metal.

Until recently, even Rio Tinto saw bauxite mining as a relatively unimportant part of its big aluminium business (Alcan) which is centred on low-cost Canadian hydro-electricity.

Most of Rio Tinto's bauxite currently goes into the integrated alumina/aluminium operations, but that's changing with the future plan being to concentrate on the two stages of the business which generate maximum profits – bauxite mining and aluminium smelting.

In its latest corporate presentations Rio Tinto pointed out that its bauxite operations had emerged as a global industry leader with third-party sales rising to a record 23 million tonnes out of last year's total of 42 million tonnes mined. More importantly, the third party sales were at an attractive profit margin of 44%.

Investment analysts who have never paid much attention to bauxite are taking a closer interest in the material with Citi last week suggesting that bauxite could be a $US1 billion business for Rio Tinto in the current financial year.

“Rio Tinto's bauxite business is growing in importance and is arguably a business that is overlooked by the market,” Citi said.

The bank's analysts estimate that the net present value of the bauxite business could rise from $US14 billion, or 10% of the firm's $US129 billion value of Rio Tinto, to around $US20 billion “if the higher bauxite prices are sustained”.

The planned South of Embley mine will be the next big test of Rio Tinto's bauxite strategy. It is expected start at an annual production rate of 23 million tonnes (the same amount of bauxite as was exported from existing mines last year), with 12 million tonnes earmarked for Rio Tinto's aluminium business and the rest available for export.

However, as market demand grows South of Embley could be easily expanded to double its start-up size.

It is a combination of demand for seaborne bauxite, the attractive profit margin, and world-class materials handling skills learned in the iron ore business which is making bauxite a significant growth option for Rio Tinto.

In some ways bauxite today looks like the iron ore of 40 years ago, a time when Rio Tinto was a modest exporter of the steel-making raw material through its Hamersley Iron business, mainly to Japan, from a single mine (Mt Tom Price) and a single jetty at the north-west port of Dampier.

From that modest start has grown the world's second biggest (after Vale in Brazil) iron ore export business.

A key to what happens next will be the way in which Rio Tinto applies its bulk materials handling skills (including automation at all stages of the process) to its bauxite operations.

What happens after that will be interesting to watch, but it's not hard to see the bauxite business follow the same broad growth trajectory as iron ore, especially as lightweight aluminium eats into markets now dominated by steel.