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Rio Tinto’s Iron Ore Division: Are More Cost Cuts Possible?

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Iron ore costs

Iron ore miners are responding to the current weak seaborne price environment by either increasing volumes, reducing costs, or both. Like other major miners, Rio Tinto (RIO) is also making efforts to improve both of these variables. Iron ore costs are key to determining RIO’s iron ore segment’s profitability, which ultimately affects its stock price and relative performance.

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Cost reduction in iron ore

  • Unit costs for RIO’s Pilbara fell 21% year-over-year to $16.2 per ton in 1H15. Based on the current exchange rate and energy costs, the cash costs should be even lower at $15.2 per ton.
  • The price decline in iron ore should have accounted for a $3.2 billion reduction in earnings. However, a cost reduction equal to $244 million—and increased volumes, coupled with a favorable exchange rate—partially offset that impact.
  • Reduced contractor and employee costs helped deliver a reduction in unit costs. Labor productivity increased by 12% in 1H15 while contractor and consultant spending reduced by 5%.
  • Increased volumes and lower costs led to a free on board (or FOB) EBITDA (earnings before interest, taxes, depreciation, and amortization) margin in excess of 60%. This is despite a 50% fall in average index price during the period.

Further lowering unit costs

  • Management pointed out that more cost cutting is possible in iron ore. Until now, it was in expansion mode.
  • RIO’s management team also commented that productivity improvements along with technological improvements, such as the expansion of its autonomous fleet, advanced analytics, and drone applications, should continue to deliver productivity benefits leading to lower costs. BHP’s management provided unit cash cost guidance of $15 per ton. ­Vale SA’s (VALE) costs fell 14% quarter-over-quarter to $15.80 per ton in 2Q15. Cliffs Natural Resources (CLF) also reduced its production costs by 9% year-over-year in the United States due to a headcount reduction and other input costs.

In a commoditized space such as iron ore mining, miners can’t control prices. Controlling costs in this scenario could be a key differentiator between the companies and could lead to stock price performance divergence. Rio is the lowest-cost operator right now, but BHP is catching up fast.

BHP Billiton, Rio Tinto, and Vale form 32.1% of the iShares MSCI Global Metals & Mining Producers ETF (PICK). The SPDR S&P Metals and Mining ETF (XME) also provides exposure to this space.

In the next part, we’ll look at the volume progression for Rio’s aluminum business.

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