As the world’s second-largest iron ore miner, Rio Tinto (LSE: RIO) (NYSE: RIO.US) has many advantages over its smaller peers. One of these advantages is the company’s low cash cost of production, which has allowed it to report a record level of profit, several times over the past five years.
Rising profits, an attractive dividend yield and the promise of additional shareholder returns were all factors that convinced investors Rio’s shares were worth 4,500p each during 2011.
However, three years on and Rio is struggling. The company has been hit by the falling price of iron ore, despite its low production costs. What’s more, Rio’s future is becoming increasingly uncertain as global iron ore output continues to increase, even though demand is falling.
Oversupplied
It’s unlikely that Rio will go out of business any time soon. Nevertheless, the company’s profit is evaporating as the price of iron ore plummets to new lows.
Specifically, this week the price of iron ore for immediate delivery into China fell $2.60 to $63.30 a tonne on Monday, a low not seen since May 2009. And it looks as if this low price is here to stay.
According to City analysts, demand for steel within China has fallen by as much as a fifth since December, as the country’s property market has cooled. But producers like Rio continue to ramp up iron ore output. An estimated 100m tonnes of fresh supply is expected to hit the market this year. The market is already oversupplied by several tens of thousands of tonnes per annum.
Rio’s production costs of $20.40 a tonne, the lowest in the industry, will help it ride out the storm. Analysts predict that the iron ore price will average $65 per tonne for the next three years.
Analysts also believe that a $1 drop in the average iron ore price wipes out $122m of annual net profit after tax at Rio. Over the past twelve months, the price of iron ore has dropped roughly $48 per tonne, wiping approximately $5.8bn of potential profit away from Rio. This figure concerning, especially when you consider the fact that Rio reported an annual net profit of $3.7bn for full-year 2013.
Knight in shining armour?
So it is clear that Rio will struggle this year and possibly even next year.
Still, Rio could be acquired by peer Glencore (LSE: GLEN) in the not too distant future. Although the chance of Glencore making an offer for Rio is becoming slimmer every day.
You see, just like Rio, Glencore is suffering as the price of key commodities slide. As a result, the company needs to try and reduce its debt burden before ratings agencies downgrade the company. A downgrade would have serious implications for Glencore’s trading arm, which requires a high credit rating to do business. On this basis, it seems as if a bid from Glencore is unlikely in the near future.
A return to 4,500p?
Overall, it seems unlikely that Rio’s share price will return to 4,500p in the near future. Until the price of iron ore rebounds from recent lows, the group is going to struggle to profits similar to those seen several years ago.
