Rio Tinto: weather or not

Investing is hard enough when we have to contend with financial uncertainty, management vagaries and competitor plots. Add the weather to these risks.

A tropical cyclone in Western Australia has damaged vital infrastructure used to transport iron ore. Both Rio Tinto and BHP have been impacted and both, within days, have downgraded full-year production.

Rio now expects to ship 333m-343m tonnes of iron ore for the full year, below earlier expectations of around 350m tonnes. 

This small downgrade is unlikely to persist but it does illustrate why the market is reluctant to embed high iron ore prices into equity prices. Stuff happens. Optimists in this game are usually disappointed.

A small restart

Another surprise came from Brazil, where regulators have allowed Vale to restart one of its mining operations. Vale has been under intense scrutiny over the integrity of its 50-odd tailings dams. Two have failed in a short time and 17 have been found to be wanting. 

A series of production shutdowns from Vale has been the basis of bullishness and is now being questioned as some operations restart. This is, in our view, no remedy to the Brazilian problem. 

Tailings dams take time to inspect and longer to repair. The likelihood of a large-scale return of operations remains low.

Yet Vale's announcement does illustrate how competing interests collide. Brazil generates substantial revenues from iron ore exports and no doubt wants production restarted as soon as possible. Its regulators must be cautious about further accidents but anxious to fill treasury coffers. 

The outcome remains uncertain, although we maintain that higher iron ore prices are likely to persist for an extended time, an outcome that isn't fully reflected in share prices today.

Beyond iron ore

Even without the price boost, Rio's iron ore business is arguably the best mining asset in the world, and we think it alone is worth $50-60 a share to Rio. Add in aluminium that's probably worth another $15 a share and it's easy to get to $70-80 a share just from Rio's two largest commodity groups. 

Copper would be worth a fair bob, too and it, along with smaller assets in the portfolio, explain why we've maintained fair value for Rio - and hence our Sell target - at $100 a share for some time.

It's worth noting that Rio has been investing heavily in the non-iron ore parts of its business and, before the price boom, we had expected the iron ore division to become a smaller part of the business over time. 

A high-quality bauxite export operation has quietly been built, hidden within the aluminium division. This bauxite business generates sensational returns and provides quality diversification from iron ore. 

Rio has also poured US$300m into Resolution copper, an American copper development jointly owned by BHP which is perhaps the best undeveloped copper mine in the world. Resolution will join a stellar copper division that includes a stake in Escondida, the worlds largest copper mine, and Oyu Tolgoi, a giant new operation in Mongolia. 

Disguised among so much quality, many also forget that Rio also operates the world's largest high-grade mineral sands business, which has expanded to the tune of half a billion dollars recently. Profitability from the bauxite, copper and mineral sands businesses should all increase in years ahead as expansion plans are completed. The storied iron ore business will always be dominant, but perhaps less than it has been in the recent past. 

Stronger for longer?

Unless, that is, booming iron ore prices stay 'stronger for longer'. Rio still remains highly leveraged to the iron ore price; a US$10 move in iron ore prices will move operating earnings by US$2bn so iron ore does matter. 

As we outlined in Fortescue: the best of times, we expect supply disruptions from Brazil to impact production for longer than many expect. Prices could stay elevated for an extended time and hence it may be worth holding Rio a little longer. 

We're increasing our Sell price from $100 to $110 but caution that higher prices are one outcome among many, and portfolio limits should be managed if the share price continues to rise. As Cyclone Veronica reminds us, anything can (and does) happen in this industry. HOLD.