Rio Tinto’s iron ore exposure a hit with Citi analysts

Rio Tinto (LON:RIO) has already outperformed the UK 350 mining sector over the year to date but Citi reckons it can continue to motor ahead thanks to a continuing tight iron ore market. The company remains the broker’s most favoured UK metals and mining stock.

Citi analysts led by Heath Jansen point out that with iron ore set to contribute 60% of earnings over the next five years, the strength of that market will be critical in deciding the future of Rio Tinto’s share price.

While the consensus view is that there is a surplus looming for iron ore supply, Citi believes this may not occur for some time.

The market has long been fixated on the looming market surplus as a result of a wave of project developments entering the market over the next four years.

Certainly the list of upcoming iron ore projects is impressive, with most of the new supply over the short to medium term likely to come from Australia and Brazil, the two expected to provide two-thirds of forecast supply growth in the next five years.

The global iron ore production project pipeline suggests over 1500 million tonnes per year of capacity yet Citi’s current supply demand model suggests only a small 50 million tonne surplus will develop by 2014.

The broker’s highly conservative stance on surpluses going forward reflects its view of a tightening iron ore market caused by a growing list of problems and setbacks that threaten to undermine near term supply.

For instance, in late June Brazilian mining giant Vale significantly downgraded its 2015 production target to 469 million tonnes (Mt) from 522 (Mt).

Citi has been sceptical of Vale’s production targets for some time and the broker’s own forecast for 2015 output by miner is actually 370Mt, which is 100Mt less than Vale’s new target.

“We see the risk of further reductions in Vale’s production target as likely,” adds the broker.

Ongoing problems, including cost blowouts and delays, with development of the 45 million tonnes per annum Oakajee Port Project and associated iron ore mines in Western Australia, presents another potentially significant drag on supply going forward.

The Oakajee project aims to open up a whole new iron ore frontier in Western Australia but now there are serious questions marks over its 2014/15 start date.

Citi says Rio Tinto continues to be the cheapest mining company amongst the large cap diversified miners including Xtrata and BHP Billiton, trading on a 2011 prospective multiple of 8 versus around 10 for the rivals, mainly because of its heavy exposure to iron ore and the market’s view of a surplus for the commodity.

As a result, the analysts believe, Rio Tinto’s share price “is already factoring in a considerable fall in the iron ore price”.

To illustrate their point, they have calculated the iron ore price needed to result in Rio trading on 10 times earning, each year for the next five years.

The results indicate that the current share price is already discounting an iron ore price falling to an average of $90 this year and an $80 iron ore price by 2015. On average this is at least $30 below Citi’s current forecast for iron ore prices.

Given the company’s large exposure to the commodity, any potential appreciation in the company’s share price will be driven by the market closing in on Citi’s analysis for iron ore pricing rather than sticking with consensus.

Rio shares have outperformed the UK 350 mining sector by 5.6% this year but Citi clearly believes the stock has further to go yet. It remains the broker’s “best pick in the sector” and a ‘buy” with a price target of £52.00.