Will Glencore make another offer for Rio?

After getting its house in order, will Glencore (LSE:GLEN) make another offer for Rio Tinto (ASX:RIO)? 

Glencore (LSE:GLEN) has bounced back in 2016, with asset sales, dividend cuts and a rise in commodity prices all contributing. After hitting a low of 69 pence in September 2015, Glencore shares have risen to over £3.42 at the time of writing.

Does this mean another offer for Rio Tinto (ASX:RIO) is on the cards?

If so, there could be some interesting consequences for the iron ore market.

Keep it in the ground

In contrast to his peers, Glencore CEO Ivan Glasenberg believes that if prices don’t justify extracting what is inherently a depleting resource – be it zinc, copper or whatever – then it should be kept in the ground until they do.

Glencore mines around 8% of annual zinc output but the company cut production by 500,000 tonnes in late calendar 2015 to bring supply and demand more into balance.  

‘When we cut back our zinc production, we looked at the benefit it had on the rest of our zinc production,’ said Glasenberg in February’s earnings call.  Since then, zinc prices have risen more than 70% compared to 15% for copper and 20% for aluminium.

Glasenberg believes that continuing to mine a depleting resource at cyclically low prices just extends the period of low prices. By leaving it in the ground instead, this helps raise prices more quickly while also maximising the returns on reserves over the long term.

Price makers

And the more of a particular commodity a miner controls, the greater the effect of such a strategy.

This is why Rio may be so attractive to Glasenberg, as it mined 330m tonnes of iron ore in 2016 (on a 100% basis), second only to market leader Vale’s (BOVESPA:VALE3) 350m tonnes.

Along with BHP Billiton (ASX:BHP) and Fortescue (ASX:FMG), these four miners control the vast majority of the seaborne iron ore market, allowing them to materially affect the price of iron ore by varying their production.

However, instead of following Glencore’s strategy, the big four miners have cranked up iron ore production in recent years.

For its part, Rio has increased production by 72% since 2011. These expansionary tonnes required relatively little investment and so earn high returns on the incremental capital employed.

Combined with some serious cost cutting, it and the other big four miners have gained market share in the seaborne iron ore market at the expense of higher cost producers. Much of the higher cost competition in China and India has exited the market in recent years.

Yet as you can see in Table 1, so far at least this strategy hasn’t resulted in higher earnings for both Rio and BHP (which increased production by a more moderate 57% over this period). Instead, revenue and earnings before interest, tax, depreciation and amortisation (EBITDA) have plummeted.

(I’ve ignored Vale because it’s been helped by the significant decline in the Brazilian Real versus the US dollar whereas Fortescue was coming off a much lower base in 2011).

Table 1: RIO and BHP iron ore returns
  2016 2011 /(–)
(%)
RIO - tonnes mined (m) 330 192 72
BHP - tonnes mined (m) 227 144 57
RIO - revenue (US$m) 14,605 29,475 (50)
BHP - revenue (US$m) 10,538 20,412 (48)
RIO - EBITDA (US$m) 8,526 21,333 (60)
BHP - EBITDA (US$m) 5,599 13,946 (60)
Note: RIO to 31 Dec, BHP to 30 Jun
Source: Capiq, company reports

This is because the firms’ still large fixed costs and the effect of operating leverage mean cost cuts haven’t compensated for the lower iron ore price.

That is, the incremental capital employed by Rio (and BHP) has had the perverse effect of reducing the returns on total capital employed.

Unlike Glasenberg, it appears Rio and BHP didn’t consider – or ignored – the effect additional iron ore production would have on their companies’ existing iron ore production.

So Glasenberg might argue that Rio and BHP’s strategy has been misguided.  

Cost support

However, perhaps prices will rise now that higher-cost excess supply has left the market.

Iron ore prices have indeed risen substantially since falling to around US$40 in late calendar 2015. However, over the long term the price of any commodity has tended to match the cost of production.

Ironically, through their expansions and incredible cost cutting efforts in recent years, the big four miners have reduced the price at which the iron ore market balances and hence the expected price of iron ore over the long term.

Do a Glasenberg?

So what if Rio under Glasenberg’s leadership instead eased back on production to bring the iron ore market back into balance?

If so, and all things being equal, I’d argue that Rio’s earnings would be far higher as a result of a higher iron ore price in such a scenario.

And if the higher price ultimately induced more supply, so be it.

New mines take many years to go from planning to full production, during which Rio (and the other big three) would still be earning higher profits. Moreover, as mining is a scale business, the new mines would almost certainly be smaller and so higher cost than those of the big four.

The same goes for any mines currently mothballed that restart operations.  

As such, once the new supply appeared, Rio could continue to manage its production to ensure a balanced iron ore market and a higher market clearing price.

This is all hypothetical, though, and has the potential weakness of Rio’s three big competitors not getting the signal and instead cranking up production to replace Rio’s reduced production.  

However, Glencore was able to help materially raise the zinc price by controlling only 8% of the market (although having a large trading operation helped).

Imagine what Glasenberg could do to the iron ore price if he gained control of Rio Tinto. 

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