Rio's rotten run may not be over yet

After already making major asset write-downs, Rio Tinto may have more offshore problems to deal with.

Summary: Rio Tinto is not out of the mining woods yet. Projects the company is involved with in Mongolia and Guinea could prove very costly if political risks become reality.
Key take-out: The governments of Mongolia and Guinea are demanding bigger shares of mine ownership and profits.
Key beneficiaries: General investors. Category: Portfolio management.

If shareholders in Rio Tinto thought all the bad news about asset-value write-downs and management upheaval has been released over the past month, then they had better think again because there could be two more big hits to come.

Neither issue is a crisis, yet, but the $6 billion Oyu Tolgoi copper mine in Mongolia and the $600 million sunk (so far) into the Simandou iron ore project in the West African country of Guinea are what might be called pregnant problems that will eventually be delivered.

Resource nationalism, a curse unleashed during every boom in commodity prices, is the reason for being concerned about the Mongolian and Guinean assets, where governments have blown their budgets in expectation of windfall gains and are demanding a bigger share of mine ownership and profits.

Anyone who doubts that comment has only to look at what’s just happened in Australia where the government has spent the proceeds of its Minerals Resource Rent Tax before it was received, and which might not ever be received.

For Sam Walsh, the newly appointed chief executive of Rio Tinto, the greatest challenge he faces is hosing down expectations of governments in Mongolia and Guinea while juggling a process of asset sales elsewhere, meeting the cash demands of expansion projects in safer countries and the expectations of shareholders who want a steady increase in dividends or share buybacks.

Investment analysts who track Rio Tinto are impressed with Walsh and his steady hand at the top of the company, which was badly shaken by the sacking of his predecessor, Tom Albanese. They have even been quick to restore Rio Tinto to their “buy” lists in the belief that all problems have been recognised in the accounts.

That might be reasonable advice if not for three problems that Walsh must address in what is likely to be his short stay in the top job given his age. They are:

  • Mongolia, where the government is already demanding reduced management fees charged by Rio Tinto, fewer high-paid expatriate executives and lower capital costs so that it can earn higher profits from its 34% stake in the giant Oyu Tolgoi copper mine.
  • Guinea, where a series of astonishingly corrupt governments have played a part in equally astonishingly corrupt deals over mineral assets, and where Rio Tinto is considering putting at least $3 billion at risk in an iron ore mine that would be an expropriation prize.
  • Over-reliance on iron ore as the company’s cash cow, with growing concern that the iron ore price is at a peak. Even the Reserve Bank has added its weight to forecasts of lower future prices as global production rises and Chinese demand falls.

Boiled down, and coupled with the poor performance of Rio Tinto’s aluminium, coal, copper and diamond divisions, you see a company that barely qualifies for the description of “diversified miner”, such is its over-reliance on a single commodity (iron ore), and such is its list of problems yet to be resolved.

The “one-trick pony” charge that can be levelled at Rio Tinto is the easiest to make, and the one which most annoys the company’s management because it was once used as a term of abuse by a former chief executive, Leigh Clifford, of other miners.

But, in the latest accounts released last week the truth of that description was on display, with iron ore accounting for 82% of the company’s underlying earnings – $US15.7 billion in earnings before tax and other charges out of a group total of $US19.1 billion.

If, or more likely when, iron ore prices contract, there are doubts about which other divisions will rise to fill the gap, causing Rio Tinto to rely heavily on asset sales to generate cash in a process that will see the company shrink over time.

Analysing the financial structure of the company, and fiddling with spread-sheets to arrive at theoretical future profits and the likely share price of Rio Tinto, is the easy part in estimating how the company might perform over the next few years.

Totally unknown, but a factor of extreme importance, is what the Mongolian government might do with the Oyu Tolgoi copper mine where $US6.2 billion has already been invested and where another $US5 billion is earmarked for expansion.

All that Rio Tinto is saying today is that it has “issues” with the Mongolian government, with the former head of the company’s copper division (and just appointed head of iron ore) Andrew Harding saying that recent meetings with the government had been an opportunity to “exchange perspectives”.

Talks might be underway, but for a glimpse of the sort of ridiculous decisions that the Mongolians can make in the mining sector it’s worth looking at the mess made of another mine, the Tavan Tolgoi coal mine that last year became a political plaything.

Plans to list the giant coal project on the London and Hong Kong stock exchanges have been shelved because the mine is effectively broke after being forced to buy-back shares issued to Mongolian citizens ahead of national elections last June.

In a process which beggars belief, the Mongolian government issued 1,072 shares in Tavan Tolgoi to everyone, then forced the company to buy them back for cash, leaving the mine with a bill of almost $US1 billion and insufficient funds to pay for trains to deliver coal to customers in China.

It is not difficult to see the Mongolian government mounting a similar raid on Oyu Tolgoi to pay for its ongoing budget problems, with the list of complaints filed with Rio Tinto about cost increases and high-paid executives very similar to the Tavan Tolgoi process that started with the removal of senior western expatriate managers.

Guinea is not yet a major headache for Rio Tinto because it has not involved the same level of investment, but it is a personal problem for Walsh who, as head of iron ore, was the man in charge of the Simandou project.

Multiple ownership changes and allegations of blatant bribery have seen Simandou locked in a dispute that has ensnared Rio Tinto as well as the big Brazilian miner, Vale, and a fleet-footed Israeli financier, Benny Steinmetz, in a web on intrigue that has even drawn in former British Prime Minister, Tony Blair, as an honest broker seeking a resolution.

The problems for Rio Tinto are in knowing precisely how much of Simandou it owns today (and how much tomorrow if the disputes can be resolved), how much it will cost to build the infrastructure to develop what is a world-class iron ore deposit, and what is the risk of sinking billions of dollars into a country with one of the world’s worst records for corruption and violence.

For Walsh, who has previously spoken glowingly of Simandou when he was the iron ore boss at Rio Tinto, the issue is whether he now feels the same way as he juggles its attraction as an investment proposition alongside competing projects elsewhere in the group – and whether it really needs a new source of iron ore to add to its Australian and Canadian production.

Oyu Tolgoi and Simandou, while not immediate problems, share a common thread with the project that cost Albanese his job, the Benga coal project in Mozambique – they are all in third-world countries where risk is always a degree or two higher than in first-world countries.

The Mozambique disaster was a direct result of Rio Tinto misunderstanding local concerns about a plan to use a river for coal transport, a seemingly insignificant issue that ended up costing shareholders $US3 billion.

The Mongolian question is about a government which has almost bankrupted itself on vote-buying sprees using mining assets as bargaining chips, and the Guinean question is simply about rotten government.

In all three cases (Mozambique, Mongolia and Guinea), there has been a stunning naivety on the part of financial analysts who tend to value minerals in the ground in those countries as if they were in Australia, with little allowance for political and social risk – because it doesn’t fit into their spread-sheet.

His first 12 months will be critical for Walsh as he juggles competing demands for Rio Tinto’s cash, with the biggest test being whether he still champions Simandou as a personal favourite now that he has the whole company to worry about.

For investors with an interest in Rio Tinto, now might not be the best time to buy. It could be cheaper later.

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