Rio Tinto (
), China's Chalco and the World Bank have signed a draft agreement
with the Guinean government to delay first production from the
ambitious Simandou iron ore project by three years to 2018 from the
original target of 2015. Rio, Chalco and the World Bank own 50%,
45% and 5% in Simandou respectively.
The project has been held up over infrastructure financing
issues. The agreement focuses on the terms and conditions that will
govern funding and construction of a 650 km long railway line to a
port from the mine. This draft agreement will serve as the basis to
work towards a binding agreement by the end of the year.
While some analysts think that the delay would reduce the
internal rate of return from the project, we think that it could be
a blessing in disguise. Iron ore prices are expected to bottom out
around 2018 due to a supply surge and an absence of a corresponding
increase in demand. Also, given that Rio is running a tight ship on
costs and capital expenditure at the moment, the delay may give the
company time to generate enough cash on the balance sheet to fund
See Full Analysis for Rio Tinto Here
Why Is Simandou Important?
Simandou is among the world's largest untapped high quality iron
ore deposits. At full production levels, Rio is expected to export
about 95 million tonnes of iron ore annually from here. This is
about one-third of its total present capacity at the moment. Apart
from the Oyu Tolgoi copper-gold project in Mongolia, it is the only
significant growth project in its pipeline at the moment. Given
that Vale, the largest producer of iron ore in the world, owns the
other half of the Simandou concession, it is imperative that Rio
doesn't fall behind. In the iron ore business, economies of scale
grant companies pricing power in the market and lower costs.
Why The Delay?
The earlier deadline of 2015 for commencing production was quite
ambitious to begin with. Continuous wrangling with the Guinean
government due to regime changes, which led to policy changes,
worsened the situation. Earlier this year, there were reports that
Rio had unofficially frozen the Simandou project over financing
issues. The bone of contention seemed to be the Guinean
government's reluctance to commit half the funds required for
construction of the crucial railway line to transport iron ore to a
port 650 km away despite a previously agreed upon obligation. The
cost of construction has been pegged at $10 billion and Rio had
explicitly expressed its inability to bear any extra costs. While a
cheaper transportation option that involved transporting the ore to
a port in neighboring Liberia was available, the Guinean government
denied permission for the same in expectation that a new railway
line within Guinea could generate economic benefits for the
local populace. For a background and history of the Simandou
project, you can read
we wrote earlier this year.
The new draft agreement seeks to break the deadlock over
financing by allowing the Guinean government to bring in a third
party to fully fund the construction of the railway and port.
Effectively, this frees the government from its obligation to fund
51% of the infrastructure. According to Bloomberg, the Chinese
government is considering whether to fund the construction of the
Is The Delay Bad News?
Not necessarily. Some analysts have expressed an opinion that
the internal rate of return from the Simandou project will be
lowered as a result of the delay. However, we think that this
analysis doesn't take into account the possible repercussions for
Rio's iron ore business as a whole. A supply surge in the iron ore
market is expected over the next few years as expansion projects by
majors like Rio, Vale and BHP Billiton fructify. Rio itself is
poised to expand its production capacity to 360 million tonnes per
year by end of 2015, from the present level of 290 million tonnes.
This doesn't include the contribution from Simandou.
Australia is a major exporter of iron ore to China and other
countries so its economic agencies track the iron ore market very
closely. According to the Bureau of Resource and Energy
Economics (BREE), the official Australian commodities forecasting
agency, iron ore prices will decline going forward and reach
its lowest levels around 2018. This is due to a lot of additional
production capacity scheduled to come online in this period and a
non-commensurate expected rise in demand. Beyond 2018, the balance
between demand and supply is likely to be more even.
Thus, by the time Simandou comes online, iron ore prices may be
on an uptick. If production from Simandou were coming online as
originally planned, price expectations would be lowered
We have a
Trefis price estimate for Rio of $55
a Company's Products Impact its Stock at Trefis