Rio Tinto vs the Mongolian monster

Rio's interim result should soften soaring profit expectations from the resources sector; there is no new boom underway. 

Operating profit from the aluminium business fell 64%; copper earnings fell 23% and the energy and minerals segment fell 27%. Most commodity prices were softer over the year and Rio has been impacted by production issues at mine sites. This was almost a disappointing result against roaring expectations. Except, that is, for the iron ore business.

Operating profits from iron ore rose 39% to US$4.5bn for the half-year and now contributes over 90% of pre-tax profits. There is no mystery about why. 

Iron ore prices have soared, alone adding US$1.9bn to earnings before interest, tax, depreciation and amortisation (EBITDA). The cheers from Rio were muted, however, because volumes fell 8% and costs crept higher.

Rio sells iron ore on a lagged price basis so realised prices did not match spot prices in the period but we expect higher prices to continue to flow into the full-year results. Some were disappointed with final profits from iron ore. Spot prices have raised expectations but, for a miner of Rio's significance, it is rare to be able to boast of higher prices and higher volumes. One inevitability impacts the other.

Mongolian monster

Outside of iron ore, things were less rosy, particularly at Oyu Tolgoi, the giant Mongolian copper mine into which Rio has invested billions. An underground expansion of the mine is currently underway and was expected to cost US$5.3bn. That figure is now closer to US$7.2bn and it will be completed two years later than expected. 

This is a risky project for Rio. Not only has it allocated billions to the mine, but Rio has also partnered with a government with a reputation for inconsistency. Rules have changed or threatened to change several times already. The Mongolian government is now demanding a higher share of project equity. Oyu Tolgoi has morphed from a 'Tier 1' mine promising investor riches into a national treasure - an asset which governments see as a development tool at best, and a booty to raid at worst. It is easily the biggest project ever undertaken in Mongolia, which itself boasts several giant mines.

Rio aims to lift copper output from 150,000 tonnes per year to over half a million tonnes from 2025, making Oyu Tolgoi the third largest copper mine in the world and one of the highest grade. 

It's easy to see why it has captured so much attention but developing the project is a daunting task.

The mine is located in the Gobi Desert, 500km from the capital. All infrastructure - roads, power and gas - must be custom supplied to the site. Rio currently mines from a monstrous open pit that could swallow all of Manhattan, and intends to chase higher grade ore deep underground. 

Rio plans to utilise a technique known as block caving, which collapses rock underneath the orebody. This is a cheap bulk mining technique, but it is hard to master. Rio must dig thousands of meters underground and selectively collapse rock to expose the covered orebody. And it has to do this without weakening the surrounding ground. One of the best examples of block caving anywhere is in NSW, where Newcrest deploys the technique to mine the giant Cadia gold mine. At its best, this is a way of cheaply mining a lot of ore. Cadia is one of the lowest cost gold mines in the world.

When block caving goes wrong, however, it can end disastrously. Most infamously, four miners died in 1999 at the Northparkes gold mines in NSW when a block caving operation collapsed access tunnels. There is already concern that Rio will have to move and replace underground infrastructure at a high cost.

Oyu Tolgoi is the single largest project outside iron ore for Rio and we question whether the market has appropriately weighted the high-risks associated with the project. We remain cautious about extrapolating targeted output and Oyu Tolgoi remains a small part of our valuation. A large write-off and lower targets remain a possibility and, given the size of the mine, the pain could be significant.

Pay up

If iron ore prices helped disguise operating pressures, they also released mountainous cash. Rio will pay a US$1.51 interim dividend and a US$0.61 special dividend, the highest interim dividend it has ever paid in its storied history.

Although this represents a payout ratio of 70%, somewhat higher than expected, low debt and decent cash flow mean higher dividends should be expected into the full year. 

A lot depends, however, on iron ore prices. Prices are high because of supply constraints, primarily out of Brazil. If those constraints ease, we should expect prices to normalise again. In our view, prices could stay high for several years, but Brazilian output is again creeping up. Conditions may normalise faster than expected. All that means we should watch portfolio limits while conditions are buoyant and profit bountiful. Now is a time for caution. HOLD.