New sources of minerals close to expanding industry are critical to future mining industry profits. Rio Tinto (NYSE:RIO) is tapping a major source of copper adjacent to the world's top market for that metal: China.
Rio Tinto is almost ready to start mining copper and gold in Mongolia. Production of ore at the Oyu Tolgoi copper mine in the central Asian nation is supposed to begin in August, which is six months ahead of schedule, a Rio Tinto executive told Reuters. The shipment of ore to customers in China is supposed to begin next year.
A successful launch of Oyu Tolgoi could give Rio Tinto's profits and stock value a huge boost because the mine is located right on the Chinese/Mongolian border. China is the world's largest market for copper. Rio Tinto would be in a position to ship copper straight to Chinese customers by rail so it would have lower transportation costs. This could ensure lower prices and a steadier supply because it would not have to ship the ore via sea.
One major savings that Rio could see from this project is not having to maintain an extensive transportation infrastructure. Instead of owning and operate its own ships, it can use the existing railroad and highway network in China.
This could make Rio the dominant copper supplier in China and to neighboring countries such as Korea and Japan. Rio might also be in a position to ship ore to Europe via Russia's Trans-Siberian Railway.
The Oyu Tolgoi deposits reportedly contain 79 billion pounds of copper and 45 million ounces of gold. Some reports indicate that this could equal 3% of global copper production.
Rio should be able to get the $5 billion it needs to complete the next phase of Oyu Tolgoi, Cameron McRae, the Chief Executive at Oyu Tologi LLC, the company that runs the mine, told Reuters. Rio Tinto own 66% of the project through its subsidiary, Ivanhoe Mines (IVN). The government of Mongolia also owns a stake in Oyu Tolgoi. Ivanhone's stock should definitely be boosted by success at Oyu Tolgoi.
The whole project will cost $13 billion. Rio Tinto has already spent $7 billion preparing the mine. McRae told Reuters that his project is the largest financing deal in mining industry history. He hopes to have all of the financing in place by the end of 2012.
Rio Tinto and Ivanhoe are taking some serious risks at Oyu Tolgoi. The project's success is dependent upon the Chinese economy, which has entered a downturn. Any substantial fall in copper demand in China could lead to serious losses on the project.
The mine doesn't have a reliable supply of electricity, yet it has to buy power from China. To make matters worse, Rio has not yet received permission to build its own power plant at Oyu Tolgoi. Construction of that plant could add another $1 billion to the project's cost.
If all that wasn't bad enough, Reuters reports that some politicians in Mongolia's parliament are demanding that the government be given a bigger stake in Oyu Tolgoi. It is doubtful that such opposition will get very far because the project is a huge boost to Mongolia's economy. Spending on it now makes up around 35% of the Mongol economy.
If Oyu Tolgoi is successful, it could lower copper prices in China and undercut profits at some of Rio's competitors. Companies that could be hurt by this include Freeport McMoRan (NYSE:FCX), Vale (NYSE:VALE), BHP Billiton (NYSE:BHP), and Anglo American. Freeport is heavily dependent on its Grasberg mine in Indonesia, for profits would be very vulnerable to this competition. One negative side effect of this project could be to drive down copper prices in China which could hurt all the producers that sell in that market.
To ship copper to China, those companies need a long sea voyage and transshipment. Rio, on the other hand, could soon be shipping copper ore directly to Chinese refineries via rail. This could give it a lock on the Chinese market and build a moat around its Chinese copper business that could push up its stock values for years to come.
If the Oyu Tolgoi project is successful Rio Tinto will see a substantial boost in its stock value. It might take years for that boost to be felt because this is a long term project that is not fully complete yet. Once the mine is up and operating Rio Tinto's share values will increase if the estimates of copper there are true. The added profit from this project should also substantially boost Rio Tinto's cash flow and dividends.
Rio Increases investment in Aussie Iron
Oyu Tolgoi is not the only big bet that Rio Tinto is making on China's economy. The company is planning to invest another $3.7 billion in the Pilbara iron region in Western Australia. Rio wants to expand export of iron from Pilbara from the 225 million tons shipped last year to 353 million tons by early 2015.
The money will be spent to build new port facilities at Cape Lambert and new rail lines connecting Cape Lambert and the mines. It will also be spent on a new gas-fired power station at Cape Lambert. Some money will also be spent to extend the life of the Yandicoogina mine.
This move is obviously a huge risk for Rio Tinto because its success is dependent on continued economic growth in China. To make a profit on its Western Australian venture, Rio needs increased steel production in China. There should be an increased demand for iron for steel in the foreseeable future because of the increased demand for autos there. Chinese auto sales volume is expected to rise by 20% in the next two years.
Iron now makes up 80% of Rio's profits, the company's chief executive, Tom Albanese, told the Australian newspaper the Age. Albanese obviously has a lot of confidence in iron; he recently compared his iron ore business to Apple's iPod.
Rio expects Chinese steel production to increase until 2030 and peak at one billion tons a year. Unlike executives at BHP Billiton, Rio's management team does not expect demand for iron or steel to fall off any time soon.
The massive investments in Western Australia, at a time when the global economy is slowing, could hurt Rio Tinto's stock values. They are exposing the company to huge potential losses, which could take years to make up. There is no guarantee that future Chinese demand will cover the cost of this expansion.
If Rio's managers are right and the Chinese steel industry continues to boom, its stock will go because they're obviously right. The company is in an excellent position to supply China with iron, particularly with the political climate in Brazil, the other major source of iron, becoming increasingly hostile to mining. Rio's bet on Australia and China could pay off.
Rio Spending More in Africa Too
Rio's spending spree is not confined to Mongolia and Australia. The Age reported that the company is planning to spend another $501 million at its Simandou iron mine in Guinea in West Africa. Most of this money will apparently be spent on rail lines and port facilities.
Commercial production at Simandou is expected to begin in 2015. Simandou, which is expected to be Africa's largest iron mine, could be a much bigger risk than Oyu Tolgoi and Pilbara. Most of the production from that mine would presumably be shipped to Europe, which is now in the midst of a serious economic downturn, so there could be no market for the additional ore from Simandou.
Another problem is that Simandou is halfway around the world from China, which is the biggest importer of iron ore. That could lead to prohibitive transportation costs, which could also cut into profits, so this looks like the kind of questionable expansion that can hurt profits and lower stock values.
To get the mine into production, Rio Tinto will have to build a deep water port and 650 kilometers of railways in Guinea. There is no indication that such expenditures are justified with the European economy in a downward spiral. The spending at Simandou could lead to huge losses that could cut into Rio's stock. Rio's partner at Simandou is the Aluminum Corporation of China (601600 in Shanghai), or Chalco.
Rio Tinto Should Retain Value for the Long Haul
The iron projects may not be as profitable for Rio Tinto as Oyu Tolgoi because they are more vulnerable to the global economic downturn. Oyu Tolgoi could give Rio a hedge against the global downturn because of the large amounts of gold there. The gold production in Mongolia could help Rio Tinto maintain its stock value and cash flow even with a substantial fall in iron and copper prices.
Rio Tinto's stock prices should remain constant even if the current economic crisis continues for several years. The reason they will stay constant is the diversified nature of the company and the many streams of income that it has. Rio's development efforts seem to be well balanced and designed to maintain cash flow in a time of economic turmoil.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.