Rio's production numbers speak volumes about Walsh's strategy

Given that Rio Tinto's strategy since commodity prices crashed is based on driving volumes to partly offset the pricing impacts, today's strong production numbers provide some reassurance that the strategy remains on course.

Achieving that volume growth is particularly important if Rio is to deliver on Sam Walsh's November promise to "materially increase cash returns to shareholders in a sustainable way" over the next five years.

It is the combination of the bigger volumes and the assault Walsh has mounted on costs that would deliver the productivity gains and cash flows to fund that promise. It might also be critical if Rio is to fight off the unsolicited merger overtures from Glencore, although that threat appears to be receding in line with Glencore's sliding share price.

Rio's December quarter production report showed that production in its core iron ore business was up 12 per cent in the quarter and 11 per cent for the year.

Shipments were up 13 per cent in the quarter and 17 per cent for the year, with Rio selling off some of the stockpiled ore it had built up as it prepared for the increased port and rail capacity it has installed as part of the big ramp up of Pilbara production, initially to 290 Mtpa and eventually to 360 Mtpa. This year Pilbara production is expected to reach 330 Mtpa, compared with 295.4 Mtpa in 2014.

The extent to which the increased volumes have blunted the impact of the dive in iron ore prices won't be clear until Rio releases its financial results next month. However, with an average realised price of $US84.3 per tonne, the full impact of the collapse in  prices won't be seen until the 2015 results are in. The spot price for iron ore is currently just below $US69 a tonne.

While Rio's volume-driven strategy has been criticised by some, notably Glencore's Ivan Glasenberg, in the first half of the 2014 financial year the combination of higher production ($US911 million) and lower costs ($US929m, or $US661m after tax) essentially offset the $US1.4 billion impact of lower prices, primarily lower iron ore prices.

It is, of course, a strategy only really available to low-cost producers like Rio or BHP Billiton in markets awash with over-supply, where their volumes displace higher-cost production.

Walsh is not just committed to the strategy but self-evidently is certain that it will generate the free cash flows that he needs to be able to satisfy the shareholder expectations that he has created.

While the five-year time frame he has put forward for increased shareholder returns provides some flexibility, the market expects some form of capital management to be announced with next month's results.

It isn't just Rio's iron ore business where lower costs and less capital intensity have been improving the underlying performance of Rio's asset base, although the Pilbara business remains pivotal to Rio's overall performance.

Production volumes in copper and gold were, thanks to the ramp-up of the Oyu Tolgoi mine in Mongolia and higher grades at Kennecott bauxite and aluminium, solidly higher while bauxite and aluminium volumes were modestly lower.

The plunge in copper prices came relatively late in 2014 but will obviously impact the 2015 results. More encouraging have been bauxite and aluminium prices where, after a wholesale restructuring of the supply side of the sector, the markets are reasonably balanced and prices have improved.

Rio's big exposure to the aluminium sector has been a massive drag on its performance in the post-crisis years but is starting to look like valuable diversification now, given the collapse in most other commodity prices.

Rio is also achieving big increases in coal volumes and, it says, significant productivity gains in its coal operations, with thermal coal production increasing 15 per cent if the divested Clermont mine is excluded. That business produced a modest loss in the first half of 2014.

Since Walsh was elevated to the chief executive position he has lowered Rio's cost base by more than $US3.2bn and has foreshadowed a further $US1bn reduction in 2015 while reducing capital expenditures by about $US4bn dollars a year.

Until now the focus for the deployment of the increased cash flows Rio has generated despite the lower commodity prices has been on reducing debt – net debt is more than $US6bn lower than it was in 2013.

With its balance sheet now in a reasonable condition Walsh ought, despite the continued falls in commodity prices, to be able to shift at least some of that focus towards rewarding his shareholders. And, in the process -- not least by demonstrating the success of the volume-led strategy -- he should be able to protect Rio from a renewed assault from the ambitious Glencore.