Rio Tinto (ASX: RIO) will soon be the world's biggest iron ore miner, surpassing Brazil's Vale (NYSE: VALE), thanks to its Pilbara expansion project. Rio's board has already approved the investment and construction of the infrastructure required to boost production from 290 million tonnes to 360 million tonnes.
Rio's iron ore division accounts for around 90% of the company's profits thanks to huge margins between its US$46 cost of production and freight (per tonne) and a spot iron ore price of around US$131 per tonne. The price of iron however relies heavily on the growth of Chinese demand, which accounts for huge amounts of the company's revenues.
Iron ore boss Andrew Harding says, "the company was aware of the impact an additional 70 tonnes a year will have on the market but remains confident Chinese demand for steel will be strong over the next decade", according to The Australian Financial Review. However Rio isn't the only company pushing harder into the iron ore market; BHP (ASX: BHP) and Fortescue Metals (ASX: FMG) are ramping up production too.
The uncertain demand from China could be one reason why Rio's board has not yet approved the production upgrade. To reassure concerned investors, who have argued for a greater return of profits, Mr Harding says the project will only go ahead if it is economically viable to do so, "There's a sense that we are building monuments to ourselves… there is nothing further from the truth. It is about generating value."
Perpetual Resources Analyst Andrew Corbett summed up Rio's boardroom decision really well: "It is a good economic return on quality assets. If demand falls away then 360 could have a significant influence on the iron ore price. If you get a realistic and sustainable growth demand profile then 360 is needed." So if the bulls are right about China, Rio stands to benefit.
Foolish takeaway
Investors who are bullish on the price of iron ore, largely from Chinese demand, have been rewarded in recent months as Rio's share price has risen. In the medium to long-term future however, if the bears are right, the miner is exposed to huge downside risks – one reason this Fool is bearish on the stock. With rising debts, poor dividends and lack of diversification there are better buys available on the market.
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Motley Fool contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies.
