Quarterly Report – 2Q10

On another front, Rio’s relationship with Ivanhoe Mines is under increasing strain. Rio owns 29.6% of Ivanhoe Mines which in turn controls the world’s largest, richest and undeveloped copper and gold deposit in Mongolia. We have no doubt that Rio would like to own 100% of the Oyu Tolgoi deposit.

Ivanhoe has other ideas and is seeking to have restrictions on the company lifted that prevents it from issuing more than five percent of the company’s shares to third party strategic investors which include other major miners.

As things are today, Rio has agreements with Ivanhoe that would give it 46.7% of the company for a total investment of US$2.5 billion. However, if Ivanhoe starts issuing buckets of shares to other investors, Rio’s position will be watered down. This situation is surely annoying Rio and at some stage we would expect Rio to make an offer for Ivanhoe and at the very least take control of the rudder.

What must be even more annoying for Rio is that Ivanhoe has approval from minority shareholders to create a shareholders’ rights plan; such a plan is designed to thwart a takeover. Rio believes that its rights have been breached and the matter is heading to arbitration.

The market seems convinced that Ivanhoe Mines is going to come into play and speculators have spiked Ivanhoe’s share price higher. Oyu Tolgoi is too good an asset for Rio to not want control of.

Ambivalence is perhaps the best way to describe the market’s reaction to the June quarter report. We do not expect Rio and the other major miners to outperform broader market indices until the tussle between the bulls and the bears over a double dip recession are sorted. Our money is on NO DOUBLE DIP.

SHARE PRICE CHARTS AND COMMENTS:

Looking at the weekly chart of Rio Tinto we can see that the uptrend that had supported the price action since late 2008 has now been broken. The share price is now trading sideways in a range with support at $40 and resistance around the $64 level. Of some concern is the bearish weekly MACD sell signal that is not only pointing lower but has recently crossed the zero signal line.

Of some concern is the potential head and shoulders topping pattern that looks to be forming. A clear break below support at the $40 level would confirm the completion of this pattern. However, the recent move back above both the psychologically significant $50 level and the 50 and 200 day moving averages is very positive. If RIO manages to break above the $55 level the likelihood of the head and shoulders pattern playing out would diminish.

STATE OF PLAY

The changes in output of the key profit drivers are shown in the following table. RIO’s copper division is battling lower grade ore at some operations, notably at the Bingham Canyon mine, the flagship asset of Kennecott Utah Copper. Not much can be done about this; although the molybdenum grade at Bingham will increase with depth and this is a positive.

At the Escondida mine the copper grade was 6% higher but maintenance activities lowered production of refined copper.

Rio has estimated much lower production from the Grasberg copper-gold mine because of lower grade and lower throughput.

The Oyu Tolgoi mine will help arrest the fall in copper production when mining begins in 2013. However, it will take 5 years to ramp up to full production.

Elsewhere a new nickel and copper mine is being built in Michigan, USA. The capital cost of the new mine is budgeted at US$469 million. Production is scheduled to begin in late 2003 and will ramp up to annual production of 17,300 tonnes of nickel and 13,200 tonnes of copper for six years.

Increased capital expenditure in Queensland has expanded production of coking which rose sharply by 29% in 2Q10 over first quarter. 2Q10 production of other coals was 14% q/q but production was 6% lower for 1H10 on a year ago.

The production targets for Australian Coal for 2010 are 9.4 million tonnes of hard coking coal, 3.3 million tonnes of semi soft coking coal, and 19.7 million tonnes of thermal coal; for a total of 32.4 million tonnes. These numbers imply a sharp 22% increase in 2H10 production to 17.8 million tonnes.

At other operations the production of uranium from ERA collapsed with 1H10 volumes down 37% on a year ago. The fall was due to falling grades and instability in the pit that was caused by un-seasonal heavy rain.

Production of diamonds soared after maintenance shut down at Argyle, and following a return to more normal production levels at Diavik, where production was increased to meet rising demand after the GFC.







There has been a lot of press concerning the slowing Chinese economy. We would emphasise slowing because China’s economy is not going into reverse. The spot price of iron ore has fallen from almost US$180 per tonne to only US$116 per tonne for 62% iron CFR North China. CFR means at the sellers expense. Chinese stocks of iron ore and steel are reportedly high and domestic steel prices are still under a lot of downward pressure. China is also ramping up its domestic supply of iron ore.

RIO has reported that total sales volumes from the Pilbara for 2Q10 of 56 million tonnes were 5% higher q/q and 6% higher on a year ago. The Pilbara has operated close to capacity over the past 12 months making shipments of 220 million tonnes.

The trend to quarterly iron ore pricing is not going to look very smart if the spot price continues to plummet. Rio’s says that 50% of its Asian customers have signed on to quarterly pricing. Sales to other customers are being provisionally priced on the same basis. This means that prices for 3Q10 will be based on the average indexed price for 2Q10.

Provisional pricing can result in some big adjustments being made and at least one junior copper producer has failed under its impact.

The watered down MRRT seemed to have an immediate effect on Rio’s decision making process. This is somewhat strange because an Aussie election is not far away and the tables could easily be turned against the miners in the Upper House. Be as it may, the company has announced that it will go ahead with a US$200 million expansion to increase the overall capacity of the Pilbara to 330 million tonnes and eventually higher.

The decision to go ahead means that contracts can be let for dredging as part of the Cape Lambert port expansion. The expansion involves a new 1.8 kilometre jetty with room for four berths. This first step will increase Cape Lambert’s annual capacity from 80 millions to 180 million tonnes per year. Other increments gradually increase capacity to 330 million tonnes per annum and include two 50 million tonne lifts.

At this point in time the market seems to agree that Rio Tinto offers more value than BHP Billiton. It seems a little unrealistic that the consensus forecasts are showing very little revenue growth from 2010 to 2013. Why Rio is particularly interesting is the company’s low forward earnings ratios (PERs).

The PERs for 2010 to 2013 are around 7 times; the corresponding cash flow multiples are very low at 5 times.

Perhaps the market is preoccupied with the old adage of sell the miners on low PERs and buy them on high PERs. We just prefer to get set in the miners near to the start of a business cycle and ride them to the top.

As far as we can see the world economy is on the mend, and we need to remind ourselves there is more to the world than just China, important as it is. RIO will remain firmly held within the Fat Prophets Portfolio.