COMMENT: Will Rio push through Pilbara iron ore ramp-up in time?

Rio Tinto is pushing ahead with its planned ramp-up of Western Australia iron ore output to 360 million tpy, new ceo Sam Walsh revealed to investors in Sydney on Monday May 6.

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The decision comes despite Rio implementing austerity measures across many of its other businesses.

The completion of the whopping second phase of Rio’s expansion at Pilbara came with a caveat, however. An additional $5 billion in mining capex will have to be approved by the miner’s board in the fourth quarter of this year.

How the project develops and at what pace will also be down to the board, which has pledged to return as much value to shareholders as possible after a rocky start to the year, which saw the miner part company with ceo Tom Albanese after writing down $14 billion on its aluminium and coal businesses.

Hurdles to clear
With investor attitude to the expansion lukewarm at best, Rio’s expansion plan faces many hurdles before completion.

Cost inflation, a strong Australian dollar and volatile iron ore prices are just a few of the factors which could sway board opinion against pumping more cash into expansion projects in the next few months.

Deutsche Bank argued that Rio’s $19 billion Pilbara expansion has one of the highest returns of any large mining project in the world, but warned that any delays to the ramping-up process could encourage other producers to fill the supply gap and set back operating cost gains.

At present, Rio plans to complete the ramp-up by the end of 2015. The first stage of the project, which will take the Pilbara operations up to a capacity of 290 million tpy, is 70% finished and is set to complete in the third quarter of 2013.

Shareholder value
Walsh promised an “unrelenting” focus on shareholder value when he took the helm of the mining company in February this year.

According to analysts at the meeting on Monday, new cfo Chris Lynch reiterated the miner’s emphasis on returning capital to shareholders but warned that the balance sheet would have “limited flexibility” until 2015.

Without significant asset sales or a deferral of capex, Rio will not be in a position to increase shareholder returns until the second half of 2014, Citibank analysts said.

“It all depends on their balance sheet, but I think they will roll [the Pilbara expansion] back at least 12-18 months,” Macquarie analyst Colin Hamilton told Steel First.

“It is not a question of whether the demand is there or how profitable the expansion would be, it is really about whether there is enough money in the coffers to make it happen,” Hamilton added.

Iron ore surplus
Citibank analysts calculate that Rio’s Pilbara expansion plans would add 70 million tonnes of iron ore to the market at a time when the market is expected to be moving into surplus, with a $15 per tonne price drop wiping out all net present value upside from the expansion programme.

Market observers fear that any delays to the project could see Rio overtaken by other projects, such as Vale’s S11D project in Brazil, formerly known as Serra Azul, expected to come online in the next couple of years.

“The bulk of Rio Tinto’s capex spend has happened already,” Hamilton noted. “If they push it back and Vale bring on [Serra] Azul in time, they will lose their payback.”

Other projects
Any decision made by Rio’s board to delay or push back the Western Australian expansion plan would have unwelcome implications for the miner’s other, earlier stage projects.

The miner has slowed work on its multi-billion-dollar Simandou development project in Guinea, citing regulatory hurdles in the west African country and delays to government funding for its half of an infrastructure project which will give the mine access to the seaborne market.

If Rio’s shareholders and board members vote against the expansion of what is its most established and profitable business, it is difficult to see how they would give approval to massive spending on a complicated greenfield project any time soon.

“A 10% change in iron ore price could lead to a 15% change in earnings for Rio Tinto specifically, on our estimates,” analysts at Deutsche Bank said in a note published on May 6.

One at a time
With shareholders still reeling from January’s massive write-downs, is it a question of just one big project at a time for Rio Tinto?

“There’s no doubt that Rio’s Western Australian iron ore operation is one of the best businesses in the world,” a fund manager commented. “The question is whether they have the cash to bring this tonnage on before we reach peak iron ore.”

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