What You Should Know About Rio Tinto plc’s $20bn Guinea Gamble

Profits are expected to rise at mining giant Rio Tinto (LSE: RIO) (NYSE: RIO.US) this year, as the company’s promise to sweat its existing assets harder, and reign in capital expenditure, begins to deliver results.

However, today’s news that the firm has signed a $20bn deal to develop a giant iron ore mine in the African republic of Guinea does seem to threaten this progress: it’s politically risky, there’s no existing infrastructure, and the iron ore market is already well Rio Tintosupplied.

Political risk

The Simandou project originally consisted of four licence areas, all of which were controlled by Rio Tinto. In 2008, Guinea’s then military dictatorship confiscated Rio’s licences for the two northern areas and they subsequently ended up in the hands of Brazilian iron ore miner Vale.

The current Guinean government is attempting to reverse this decision, but Rio’s decision to proceed relates only to the two uncontested southern concessions at Simandou. The deal looks ok now, but political risk will always be greater than for Rio’s Australian iron ore mines.

Will Rio really spend $20bn?

Rio believes Simandou should provide a mine life of more than 40 years and will be able to produce 100 million tonnes of iron ore per year at peak production.

Although the headline estimate cost figure for the project is $20bn, Rio won’t be spending this much. The Anglo-Australian firm has a 46.57% stake in the project, while its Chinese partner, Chinalco, owns a further 41.3% and will provide most of the remaining costs (the Guinean government has been given a free 15% stake in the project).

The 650km railway and new port which will be required for the project are thought to account for around two-thirds of the estimated $20bn cost, and to cut capex commitments Rio has agreed that a consortium of third-party investors will fund, build and operate this infrastructure, which will also be available to other users.

Simandou production is expected late in 2018, and based on my rough estimates, getting this mine up and running should cost Rio Tinto around $3.5bn.

Could be a winner

I’m not too concerned about the risk that Simandou will drive the iron ore market into surplus. The mine’s iron ore is expected to be high quality and low cost, so other producers should feel the pain long before Rio does — plus Chinese demand is likely to continue to rise for some years yet.

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Roland owns shares in Rio Tinto but not in any of the other companies mentioned in this article.