We do not usually write cheesy headlines in the Daily Reckoning. But looking over Rio Tinto’s half yearly results and presentation yesterday, we couldn’t help it. The presentation was all about iron ore.
That shouldn’t be too surprising. After all, in the six months to 30 June iron ore accounted for nearly 85% of Rio’s earnings — and to think it’s still called a diversified miner.
As if to allay fears that investors might have over its iron ore exposure, Rio dedicated many slides to the all-important sector. CEO Tom Albanese kicked off with the China card. ‘China Stimulus supports Q4 demand, but near term risks remain.’ In other words, there are some short term issues related to the broken Western consumption model, but China will more than make up for this.
He then goes on to list all the plans announced by central and local governments over the past few months, obviously implying that these announcements are good for iron ore demand. Maybe they are. Maybe they’re not. Maybe these plans won’t all see the light of day. After all, there is a big difference between boldly announcing some mega-project, and financing it.
Although all it would take is for the government to direct its state owned banks to hand the money over. The banks, practicing a primitive form of risk management (if we don’t hand over the money we’ll lose our jobs and seats on the gravy train) do as they are told.
Most apologists for central planning would argue that this is exactly what should happen. The economy slows, so the government should spend more to prop up growth. What this reasoning fails to understand is that the government doesn’t have any money. It either has to borrow it by issuing bonds, or the banks providing the loans must borrow the money from somewhere too…either from their depositors or through issuing corporate bonds.
In a closed capital market where foreign capital inflows are restricted, most of this money comes from the Chinese household sector. In the good old days of burgeoning trade surpluses and rising foreign exchange reserves, the household sector could fund this profligate spending with ease. That’s because as the FX reserves flowed in, the People’s Bank of China would print yuan to maintain a fixed exchange rate with the US dollar. It was liquidity heaven.
But the slowdown in Western consumption, combined with wage increases in China which make exports less competitive, mean the flow of dollars and euros have slowed to a trickle. The fixed exchange rate, pretty much the source of China’s epic liquidity and credit boom, no longer has its once powerful effect.
So the ability of the household sector to keep funding infrastructure investment is not as strong as it once was. It can still do so, of course…that’s what financial repression is for. But calling on the household sector to finance another round of infrastructure spending will delay the desired rebalancing away from investment led growth.
Which brings us back to Rio and iron ore. Yes China may have announced all these iron ore hungry measures, but how much extra demand will they really bring about? With weaker overall demand and a big increase in supply hitting the market over the next few years, what will happen to prices? They’ve already fallen heavily from all-times highs of around US$180 per tonne. But at current levels of around US$116 per tonne, they are still well above historic levels. In its presentation yesterday, Rio pointed out that a 10% fall in the iron ore price would wipe US$1 billion from its bottom line. Ouch.
With iron ore being so overwhelmingly important to Rio (and to a lesser extent BHP) we wondered how the divisions’ profitability had changed over the years. So we went back through the annual reports from 2005. In 2005, you might remember, the China boom was hitting its straps. Kids not far out of school weren’t quite getting paid $150,000 to drive a big truck, and the tattoo revolution was still to take off, but things were warming up nicely.
Below we show Rio’s iron ore divisions’ return on assets. In 2005 and 2006, Rio only provided ‘operational earnings’ in its annual report, which is earnings before interest and tax. So for those years we adjust for a 30% tax rate and assume no interest payments. From 2007 onwards, we use net profit divided by operating assets, as provided by Rio.
Rio Tinto’s Iron Ore Division Return on Assets
2005 – 27.8%
2006 – 26.7%
2007 – 28.6%
2008 – 78.8%
2009 – 36.6%
2010 – 87.6%
2011 – 96.1%
2012 – 51% (half-yearly annualised)
There are a few things to take into account here. We’ve included a chart of the Reserve Bank’s commodity price index to help out.
The big jump in 2008 profitability was due to a big spike in prices as well as an asset value adjustment in Rio’s books that year. The dip in 2009 related to the credit crisis while the incredible rebound in 2010 and 2011 was all about China stimulus.
Now in 2012 things look like they have come off the boil. But much of the decline in profitability relates to a big increase in iron ore asset values. This reflects Rio’s major expansion projects to increase production over the next few years. Without the increase in asset value, the iron ore division still generated profitability of around 70% in the first half of 2012.
For all the talk of gold being in a bubble, we haven’t seen any major gold producer managing to generate profitability of 70% or greater…for three years running. Granted, the economics of mining iron ore versus gold are entirely different. One is plentiful and the other is precious.
Yet the market, in all its manipulated and coerced wisdom, says the reward for digging up iron ore is many times greater than that for getting gold out of the ground…a much tougher process. In fact, the rewards for shipping iron ore to China are greater than for any other commodity we know of.
This could mean a couple of things. That we are in a massive iron ore bubble, inflated by the genuine belief in China’s industrialisation process and its ability to maintain investment led growth at all costs. Or it could be that China’s economic rise is unprecedented in size and scope, and that very high returns on assets are sustainable given this view.
We’ll opt for the first option. And as you can see from the chart, the bubble bust has begun. The rest of 2012 will be about China’s ability to reinflate this bubble (indirectly) and keep Rio Tinto, and the Aussie economy, humming along.
for The Daily Reckoning Australia
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