Rio to ride the commodity bull

Rio Tinto expects to skate over a possible fiscal cliff and believes that prospects for commodities will be strong for decades to come. Demand for iron ore will rise over 50 per cent by 2025, they say.

Rio Tinto’s chief economist thinks that commodities will effectively skip over the fiscal cliff, if such a disaster were to come to pass.

Vivek Tulpul agrees that failure to avert the fiscal crisis could have as much as a 4 per cent impact on US GDP but believes that such an event would trigger a fresh wave of stimulus by the Federal Reserve, as well as by the Chinese government.

That Chinese stimulus would be particularly supportive of iron prices because the Chinese government would pour money into steel-heavy infrastructure projects rather than repeat the mistakes of 2009 when it shovelled money into inflation-inducing consumer activities.

As the chart below shows, the stimulus across the world helped put a rocket under iron ore spot prices.

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Source: Rio Tinto

A fiscal cliff scenario would support big iron producers like Rio Tinto in the medium term too. One of the reasons iron ore leapt to $180 a tonne in 2011 is that a number of iron projects were put on hold due to the global financial uncertainty, when lenders all pulled back from expensive projects. That meant that production of iron ore was low at a time of highly stimulated demand.

Rio’s economist, Vivek Tulpul, says the shock that would hit world banks would trigger a similar capital flight and bring down global production.

In the longer term, Rio is still very bullish on iron ore and predicts prices to remain strong for decades yet. The economics team at Rio takes the view that the Chinese economy will head back to plus 8 per cent growth next year (as long as the fiscal cliff is avoided) and that the rapid urbanisation of that country’s population will see continued demand for steel.

Looking at the use of steel per capita, Rio has analysed how much more intensely countries use steel as they become wealthier.

China, which still has 700 million people living in rural areas – and rural accommodation – is expected to see 300 million of those residents shift to the cities over the next two decades.

That means more residential towers, more offices and more public transport infrastructure – all of which require steel.

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Places like Beijing and Shanghai (which is one of the fastest growing cities in terms of skyscraper construction) are not going to be the biggest factor in this change. There are 330 million people living in regional cities who will increasingly be housed and work in tall buildings as their wealth increases.

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The steel use per capita, which the chart above shows on the Y axis, is still very low in China at about 200 kilograms per head. Historically, when countries attain wealth of $20,000 per capita (adjusted for purchasing price parity), their consumption generally tends to settle around 600 kilograms per person. This is the case for the US and Germany, when they attained per capita wealth of $20,000.

These demographic shifts are just one part of Rio Tinto’s bullish assessment of continuing strong prices for core commodities. China will drive the majority of demand over the next two decades but at as China’s economy transforms to a more balanced one, says Vivek Tulpul, other South Asia nations like Vietnam and Indonesia will also become major producers and manufacturers of steel. The big sleeping giant is India, says Tulpul, which will become the main driver of commodities growth by 2025 and whose population is not constrained by the ageing demographics of China.

So Rio takes a long term bullish approach to global commodities. That’s not to say it won’t be volatile. The gyrations in the US and Europe and the patchwork development of poorer nations will mean that prices will fluctuate, as the first chart for spot iron ore above shows.

But Vivek Tulpul believes that demand for some commodities will at least double and many will grow by 50 per cent over the coming decades.

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Rio wouldn’t divulge its forecasts for iron ore, but it does believe that a comfortable floor will exist, based on their research. When you are one of the dominant players with world class assets, perhaps a bit of volatility to help shake out some of the less profitable players doesn’t look so bad.