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How low will Rio go?

Rio Tinto’s (ASX:RIO) share price is down 22% for the year. It’s no secret why. Over the past 12 months the iron ore price has been cut in half, and currently sits at just over US$68 per tonne, a far cry from the US$135 per tonne that Rio enjoyed this time last year.

There are two major factors that will decide Rio’s fate. The price of iron ore, and the value of the Aussie dollar. Thankfully for Rio, the two are linked.

It’s all about iron ore

Rio doesn’t just mine iron ore, but the commodity is far and away the driver of Rio’s fortunes.

In 2013, Rio’s iron ore unit accounted for just over half of Rio’s total revenue, but astonishingly, was responsible for 96% of the company’s underlying earnings.

Make no mistake about it. The Rio story is an iron ore story. And with Rio’s iron ore production set to expand significantly over the coming years, that dependence will only increase.

What is a ‘normal’ price for iron ore?

The collapse of iron ore prices has been dramatic. But we have to consider it in the context of the recent boom.

The chart below tracks iron ore prices over the past 15 years. This year is the first in a decade that global seaborne iron ore supply has exceeded demand. In 2004, the last year that iron ore supply exceeded demand, the average iron ore price was below USD$30 a tonne.

Untitled

(Source: Indexmundi)

In the long run, the price of a commodity should allow a small profit for producers above the marginal cost of production. If the price trades too far above that, it attracts new investment, leading to increased supply and a fall in prices. Too far below, and producers are pushed out of business, reducing supply, and ultimately increasing prices.

If we model out Rio’s current financials, its 2013 breakeven cost was around $42. Other large miners such as BHP Billiton (ASX:BHP) and Vale (NYSE:VALE) report break-even costs in a similar range of $40-$50.

We should not expect a return to the recent normal iron ore price of over $100 a tonne. Taking a longer view of iron ore, it is readily apparent that a long-run normal price is well below what we have seen in recent years.

For the past decade, China’s unprecedented investment boom has been able to soak up any iron ore demand that has been thrown at it. The next decade is unlikely to be so accommodating.

How low will Rio go?

If the current level of iron ore prices continues for the next several years, then I estimate the intrinsic value of Rio to be around $35 per share, at the current exchange rate. If that seems like a big fall from current levels then bear in mind that iron ore accounted for almost all of Rio’s profits in 2013, a year in which prices were over USD$120 per tonne.

A flat iron ore price from here on out should actually be considered a win for Rio. With global production still increasing, China’s softening demand, and the low cost of the largest producers, a price of US$60 or below does not seem unreasonable.

Rio’s only saving grace is that it, along with other miners such as BHP Billiton (ASX:BHP), are so large relative to the Australian economy that they have an outsized impact on the value of the Australian dollar.

An Australian cost base, and US dollar denominated revenue, means that any drop in the Aussie dollar falls straight to Rio’s bottom line. If the Aussie dollar falls to US$0.75 then even an iron ore price of US$65 could support the current valuation.

Foolish takeaway

Rio's intrinsic value is inextricably linked to the iron ore price, and the value of the Australian dollar. After a decade of iron ore demand exceeding supply, a new wave of production and softening demand mean that Rio needs to adjust to a new normal of lower prices.

If the Aussie dollar continues to fall it will soften a lot of the blow, but investors shouldn't be pinning their hopes on a big rebound in iron ore. There is a new normal in town.

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Matt Joass is a Motley Fool analyst. You can follow Matt on Twitter @TMFMattJoass. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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