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Is Rio Tinto a buy?

Australia’s largest iron ore miner, Rio Tinto (ASX:RIO), will have the infrastructure in place to produce 290 million tonnes of iron ore annually by early next year, setting the company up for a short jump to its target of 360 million tonnes.

But the company has yet to sign off on the estimated US$6 billion in expansion costs required to get it over the line, as the miner ponders whether to go with developing the potentially monster Koodaideri mine, or squeeze the additional tonnages from its existing operations. Koodaideri is apparently a 50-70 million tonnes per annum proposition, that also comes with an equally large price tag.

Should iron ore prices remain fairly high, we could see Rio aiming for above 400 million tonnes of production annually. And despite views from analysts that the iron ore price was going to drop below the US$120 per tonne support level, it has stubbornly remained above US$130 a tonne and is currently at US$138.70 a tonne. In Australian dollar terms that’s around A$156, and represents a very nice margin for Rio, which is one of the lowest, if not the lowest, cost producer in the world.

Rio’s shares hit their lowest levels of $49.81 twelve months ago as the spot iron ore price fell to a record low of US$86.70 a tonne. Since that time, the shares have been on a rollercoaster ride, hitting $72.30 in February this year, before easing to just above $50 in June. The shares are currently trading around $60.80, putting the company on a prospective P/E ratio of 11.7, which at first blush appears inexpensive.

But a bet on Rio is a bet on the future direction of the iron ore price. Iron ore represents close to 90% of the companies net profit, and that will likely move higher as Rio increases its iron ore production. As a commodity, iron ore prices are primarily driven by supply and demand economics. So far, demand from China has held up pretty steadily, and doesn’t appear to be waning. In fact, in July, Chinese iron ore imports reached 73 million tonnes, 26% higher than last year.

On the supply side, production is also jumping. The big three of Rio, BHP Billiton (ASX:BHP) and Brazil’s Vale are all lifting output substantially, while Fortescue Metals Group (ASX:FMG) is on track to meet its target of 155 million tonnes annually. Hancock Prospecting’s Roy Hill project is expected to produce 55 million tonnes in late 2015, while junior miners such as Atlas Iron (ASX:AGO) are also ramping up production.

Foolish takeaway

As a low cost producer Rio will benefit from expanding its iron ore operations, as long as demand from China stays strong. While that appears to be stable at the moment, demand could drop off suddenly at any time, crushing the iron ore price, and with it the share prices of the miners. A wait and see approach might be the best bet for Foolish investors.

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Motley Fool writer/analyst Mike King owns shares in BHP.

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