Rio Tinto - BHP Billiton deal highlights strategic importance of seaborne iron ore

The hullabaloo around Rio Tinto's abandonment of its posed near-USD 20bn capital injection from smaller rival Chinalco, replaced by the announcement of a general rights issue to raise the equivalent of USD 15.2bn, and agreeing a monster joint venture with BHP Billiton over the two companies' West Australian iron ore assets, has sidelined the potential focus that investors could direct to one of the world's most valuable franchises. 

The franchise is, of course, seaborne iron ore, where Rio Tinto ranks No 2 after Brazilian supergroup Vale, and ahead of No 3 in BHP Billiton. Whatever the realities, or perceptions, of global economic issues, the world's three, and totally dominant, seaborne iron names were already turning in super profits from iron ore during 2006, followed by further rounds of such profits in 2007 and 2008, with good signs of more to come. 

New keys to the value of the franchise can be seen in today's announcements, not least the clue that BHP Billiton will pay Rio Tinto USD 5.8bn "for equity type interests at financial close to take its interest in the joint venture" from 45% to 50%. This values the full joint venture at USD 116bn, more than the market value of any mining company in the world, bar BHP Billiton, the world's biggest diversified resources stock. 

Rio Tinto's iron ore interests cover Hamersley Iron and Robe River in Australia, Iron Ore Company of Canada, Corumbá in Brazil, and the Simandou, Guinea, and Orissa, India, projects. BHP Billiton's iron ore interests cover integrated mine, rail and port operations in the Pilbara, and 50% of Brazil's Samarco, with integrated mine, pipeline and port operations producing iron ore pellets, and a 50% partner in the form of Vale. 

The value of the global seaborne iron ore franchise is very different to inland iron ore markets, especially when low grade iron ore is involved, in turn, more often the case than not. In terms of country production, China ranks as the biggest iron ore miner by far, with around 770m tonnes of the stuff dug out during 2008, followed by Brazil, mainly Vale, with 390mt, Australia with 330mt, India with 200mt, and Russia with about 100mt. But low grade mines are highly sensitive to economic conditions; recent estimates by a Rio Tinto executive put current Chinese mainland production down by up to 50% from rates seen during 2008. 

By way of contrast, it can be shown that for high grade miners of seaborne iron ore, the softness in global economic conditions has been of only mild importance, so far. In numbers released today, Rio Tinto shows underlying earnings from its iron ore division for the first quarter of 2009 at USD 988m, compared to USD 916m for the first quarter of 2008. Earnings in all other group divisions collapsed, during first quarter 2009. 

The Big Three in seaborne iron ore enjoy enormous flexibility. During the first quarter of this year, Vale reduced its iron ore production by 27% to 49.8m tonnes, compared to the first quarter of 2008; pellet production was slashed down 73% to 2.9m tonnes. Even so, Vale's adjusted EBITDA (earnings before interest, depreciation and amortisation) from ferrous minerals, mainly iron ore, was reported as USD 2.2bn for the first quarter of 2009, compared to USD 2bn for the first quarter of 2008. 

Iron ore remains the backbone of Vale, by a long way; its USD 2.2bn EBITDA from ferrous minerals for the first quarter of this year comprised the vast bulk of its group EBITDA, at USD 2.3bn. It was almost as if the rest of Vale's substantial mining activities were away fishing, including mines producing nickel, copper, kaolin, potash, platinum group metals, gold, cobalt, aluminium, alumina, bauxite, and coal. With ferrous minerals revenues of USD 3.5bn for the first 2009 quarter (including minimal contributions from ferroalloys and manganese), Vale's EBIDTA margin for ferrous minerals was 63%. The comparative figure for the first quarter of 2008 was a more modest 47%.

In Vale's nonferrous division, EBIDTA was trashed from USD 1.8bn for the first quarter of 2008 to a mere USD 151m for the first quarter of this year. For their part, investors have largely forgiven Vale its misadventures (for now) outside the iron ore arena, and have continued to recognise the huge value of its core business. Most commodity prices have recovered sharply over the past, in particular, five months, pointing to supportive margin rises in Vale's nonferrous division, and also even for ferrochrome and manganese. 

The world's relatively new superfranchise did not fall out of the sky. The evolution of iron ore prices has taken place over a difficult and protracted timeframe, and the three senior names in the seaborne game are unlikely to allow any serious undermining of one of the world's most profitable businesses. Iron ore prices started to move during 2004, after more than two decades of trading in a churning band between USD 0.22 and USD 0.40 per dry metric ton unit (mtu).

The individual pricing of iron ore products differentiates chiefly between lump and fines, with lump trading at a premium to fines. Iron ore prices roared upwards in 2005, but the 2008 settlements were unprecedented both as to value and also percentage escalation.

On 23 June 2008, Rio Tinto announced annual that contract iron ore fines prices had been raised by 79.9% year-on-year to USD 1.4466/mtu, while its lumps price was hiked up by 96.5% to USD 2.069/mtu. Last week Rio Tinto cut its contract fines price to USD 0.97/mtu, and its lump to USD 1.12/mtu. 

Rio Tinto's contract iron ore prices
US cents per dry metric ton unit		2007	2008	Change	2009	Change
Pilbara Blend Fines/Yandicoogina Fines		80.42	144.66	79.9%	97.00	-32.9%
Pilbara Blend Lump		102.64	201.69	96.5%	112.00	-44.5%

 

The latest round of price adjustments leave contract iron ore prices well above those that were settled for 2007. The annual settlement of contract iron ore prices has become increasingly tense, and the iron ore spot market is slowly but surely coming into its own.

BHP Billiton's iron ore division EBIT (earnings before interest and tax) for 2007 was USD 2.7bn, on turnover for that division of USD 5.5bn, for an astonishing EBIT margin of 49.4%. The margin was maintained during 2008. 

It may not be as well known as KFC, but the Carajás name, synonymous with the world's biggest miner of seaborne iron ore, has become one of the most powerful tollgates on international waters. The Big Three dominant names mine huge, high grade deposits, and control, if not own, much of the logistics vital to the trade: rolling stock, railway lines, ports, handling facilities, and, in the case of Vale, an entire monster shipping fleet. During 2008 Vale invested USD 1.6bn in 12 "large" iron ore carriers. 

BHP Billiton
2008, USD bn	Divisional	Underlying	EBIT
	revenues	EBIT*	margin
Petroleum	9.547	5.489	57.5%
Aluminum	5.746	1.465	25.5%
Base Metals	14.774	7.989	54.1%
Diamonds and other	0.969	0.189	19.5%
Stainless steel materials	5.088	1.275	25.1%
Iron Ore	9.455	4.631	49.0%
Manganese	2.912	1.644	56.5%
Metallurgical Coal	3.941	0.937	23.8%
Energy Coal	6.560	1.057	16.1%
Group/other items	0.481	-0.394	-81.9%
Totals/average	59.473	24.282	40.8%
* Earnings before interest and tax

The proposed iron ore joint venture in the Pilbara has been under investigation by Rio Tinto and BHP Billiton for a decade. Both companies believe the net present value of potential synergies will be in excess of USD 10bn, on a 100% basis. According to announcements today, the substantial synergies are anticipated from:

• Combining adjacent mines into single operations;
• Reducing costs through shorter rail hauls and more efficient allocations of port capacity;
• Blending opportunities which will maximise product recovery and provide further operating efficiencies;
• Optimising future growth opportunities through the development of consolidated, larger and more capital efficient expansion projects; and
• Combining the management, procurement and general overhead activities into a single entity.

It seems that corporate egos have played a substantial role in delaying the establishment of the joint venture. BHP Billiton walked away from its proposed takeover of Rio Tinto back in November 2008. In the Rio Tinto 2008 annual report released in mid-March, erstwhile chairman Paul Skinner stated that "during the term of the offer, our board monitored the situation closely and nothing changed our view that the BHP Billiton bid significantly undervalued our assets and future prospects". 

It seems that franchise power has won the day. Something of a similar trend is discernible in the global potash sector, where around 80% of production comes by way of just seven companies in the form of PotashCorp, Belaruskali, Mosaic, K+S, Silvinit, Uralkali, and ICL. PotashCorp, the biggest, and one of the world's top 10 miners by value, has slashed production of its core product, stating unabashedly that its curtailments are "consistent with our long-held strategy of matching supply to market demand". The majority of mining subsectors are far too fragmented to reengineer supply, from time to time, in ways that can preserve degrees of soundness in margins, and must instead live on the margin as price-takers, churning from boom to bust and back to boom.

 

Mineweb is a web-based international mining publication focusing on mining financial and corporate news and comment.