Rio Tinto’s Three Pillars of Growth for 2008

Iron ore, copper, and aluminum. These are the tangible goods Tom Albanese must keep under his pillow at night. Granted it must be a little lumpy. But a man can sleep soundly when the ground beneath his feet (or the ore underneath his head) is solid.

Rio Tinto (ASX: RIO) out-punched BHP Billiton (ASX: BHP) in the half-year-results contest. Rio Tinto reported $8.3 billion in “underlying profit.” Diggers and Drillers editor Al Robinson looks at BHP Billiton side-by-side with Rio Tinto and says, “Both had negative earnings growth at the bottom line (BHP Billiton -2.8%, Rio Tinto -1%). Both had positive earnings after strategically removing a few significant items (2.8%, 2%).

“Rio Tinto’s result was slightly above expectations, and BHP Billiton’s slightly below,” Al says. “The two ‘slightlys’ add up to a ‘significantly’, as Rio Tinto will tell you. Rio Tinto says it has a much a better future growth profile than BHP Billiton and will profit more quickly from rising iron ore and aluminium prices.”

Albanese says Rio Tinto’s “stellar” year comes from the “three pillars” of its business: iron ore, copper, and aluminium. Rio Tinto reached production records last year for ore, copper, bauxite, aluminium, copper, and gold.

Everyone knows that the contract price for iron ore will probably go up by at least 50% this year. Rio Tinto increased production in Western Australia. It also recently announced its plans to develop the Simandou deposit in Guinea. The company says mineralization there indicates 8-11 billion tonnes of high grade hematite ore, with targeted annual production of 70 million tons per year year.

Look on a map and you’ll see that Simandou, on the West Coast of Africa, is a long way from China, where Rio Tinto’s chief ore customers are. “Over the long term,” Albanese said, “we have outlined our capability to produce 600 million tonnes… annually, based on an unrivalled and unconstrained Pilbara port and rail infrastructure and our extensive global resource and mineralisation position.”

Hmmn. There’s a big difference between capability and actuality. But Rio Tinto’s point is well-taken. It’s more leveraged to an increase in ore prices than BHP Billiton and thus, BHP Billiton should, you know, sell its oil assets already and pay more cash for Rio Tinto’s ore assets. At least that’s what Albanese seems to be saying if you read between the lines.

Here’s a thought, though. Maybe Rio Tinto’s choicest assets aren’t its iron ore assets but its bauxite and aluminium assets. Hold your scorn for a moment.

We know that aluminium has lagged (badly) copper, zinc, lead, and iron ore prices (see chart below). But we reckon that could change in the next 18 months.

Selected Metals Price Indices
Source: International Monetary Fund (IMF)

Aluminum has trailed the other metals thanks to massive increases in Chinese production of the metal. A fall-off in U.S. demand from the housing bust has been more than compensated for by rising Chinese demand. To meet that demand, China has ramped up domestic production. Increases in China’s smelting capacity have flooded the world with cheap aluminium and held prices down.

Primary Production of Aluminum by Country

Granted, the main material for ingredient, bauxite, is abundant and usually pretty easy to find and mine. It’s not like finding and digging for gold. But there’s a catch.

It’s power. The big cost for aluminium is electricity. Aluminium is sometimes called “solid electricity” because of the amount of juice it takes to smelt it.

Producing an energy-intensive metal in an energy-scare world is not a long-term strategy for mega profits. You can see where we’re going with this. The Chinese electric grid is already strained. With rising thermal coal prices, China is paying more to keep its fleet of coal-fired plants operating. It is already cutting back aluminium production to divert electricity to other industrial and retail users.

Our point?

This year, we may a shift in global aluminium production away from places where electricity is generated by coal (China) and TOWARDS places with cheaper, or even renewable sources of energy (North America and the Middle East). In the interim, however, it makes sense to us that reduced Chinese production may favour the share prices of some North American and Australian producers.

That’s a very short list, mind you. Right at the top is Rio Tinto, which looks to have another card to play in its game of poker with BHP Billiton. Another beneficiary will be Alcoa (NYSE:AA), the Pittsburgh-based producer.

Everyone thought that BHP Billiton would bid for Alcoa after Rio Tinto bought Alcan. But BHP Billiton went straight for the bigger prey, leaving Alcoa out alone in the cold North American winter, looking for a little love.

Because its Valentine’s Day, let us speculate that Alcoa may soon receive some love from a larger bidder (Anglo-American, Vale, or Xstrata). Actually, looking at the chart below, it’s clear that someone fell in love with Alcoa yesterday. The stock was up 6% on the day and closed within kissing distance (a chaste kiss, mind you) of its 100-day moving average. Hmm.

Smooch! Alcoa (NYSE:AA) Moves up towards 100-day Moving Avearge
Alcoa 100 Day Moving Average

The other part of this story is more complex and more strategic, so we’ll have to save it for another day. But the short version is this: if China is cutting aluminium production because energy is getting more expensive, it could mean aluminium production is migration to parts of the world where energy is cheaper. And where could that be?

Try the Middle East, where over US$20 billion worth of aluminium smelters are being built by the likes of Dubai, Saudi Arabia, Qatar, and Oman. The Saudi’s say aluminium could become the “third pillar” of an industrial base built on oil, gas, and petrochemicals. Remember, Saudi Basic Industries Corporation paid US$11.6 billion last year for GE’s Plastics Unit.

Say what you want about the strategy of diversification away from oil and energy towards metals and plastics. But doesn’t that seem like a better investment than recapitalizing American financial institutions?

Everyone has known that plastics are a great business since Mr. McGuire tells Benjamin (played by Dustin Hoffman) to get into them in “The Graduate.” That was 1967. Mr. Mcguire was just thirty years early. But the Saudis as aluminium makers? Think about it.

And while you’re at, think about how much closer Saudi Arabia is to Guinea than China. Guinea is home to some of the world’s richest untapped bauxite deposits. For now.

And how goes the bear in credit? Add the “auction securities market” to your list of toppling credit dominoes. “A collapse in confidence in a $330bn corner of the debt market has left US municipalities and student loan providers facing spiraling interest rate costs. The implosion of the so-called auction-rate securities market is the latest incarnation of the credit crisis,” reports today’s Financial Times.

“Its slump this week has pushed interest rates as high as 20 per cent for bodies such as the Port Authority of New York & New Jersey to a Minneapolis hospital. ‘The auction securities market is falling apart,’ said David Cooke, chief financial officer at Park Nicollet Heath Services in Minneapolis. Municipal borrowers are scrambling to seek letters of credit from banks and other new sources of finance, but anxiety in the credit markets and uncertainty about the stability of bond insurers is making this difficult.”

Just what the banks needed. Credit is tight already. But hey, that’s what happens in a bear market in credit. During the boom, financial institutions grew earnings by expanding their balance sheets through leverage (borrowing money cheap, lending it dear).

In the bust, everyone downsizes, retreats, retrenches. The only things that grow in a bear market are fear and volatility and the list of mistakes made by central bankers. Asset-based wealth generation… not so much.

Dan Denning
Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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