Rio Tinto Limited (ASX: RIO) has fallen by 4% in the last month. Other resources stocks such as BHP Billiton Limited (ASX: BHP) and Santos Ltd (ASX: STO) are down by 2% and 28% in the same time period. This has made it a poor month for resources stocks, but in my view things could get worse for Rio Tinto.
Iron ore
A key reason for this is the outlook for iron ore. Rio Tinto relies on the production of iron ore for 60% of its profits. The steel-making ingredient has endured its largest losing streak in more than five months due in part to the impact of additional low-cost supply. Its price has declined by around 6% in the last week and it posted its longest run of daily declines since March.
Further falls are on the horizon. The supply/demand imbalance is set to worsen due to a forecast for an increase in exports of iron ore from Australia and Brazil of 6.5% next year. This is ahead of the expected increase in demand for Chinese imports of iron ore of 0.7%. Additional capacity increases are expected next year including Vale's S11D project and Roy Hill Holdings' mine in the Pilbara.
Additional development post-2016 could cause the iron ore price to endure a prolonged period of decline in my view. Alongside this is a transition by China towards a consumer-based economy. As the world's largest importer of iron ore, a reduced focus by China on infrastructure projects could be bad news for the iron ore price and for Rio Tinto.
Strategy
Rio Tinto's response to a weaker iron ore price is likely to be further cost cutting. It has already enjoyed success on this front. For example, in the first half of the 2016 financial year it has achieved US$0.6 billion of sustainable operating cash cost improvements. This has helped to maintain its position as the lowest cost iron ore operator among its peers. While this means it is well-positioned on a relative basis, Rio Tinto may not be able to cut costs as quickly as the fall in the iron ore price.
Although diversifying its business away from iron ore would be a logical step, Rio Tinto's capital investment is relatively modest. Further cuts to capex of 47% took place in the first half of financial year 2016. This may make Rio Tinto's dividend more affordable but given the outlook for iron ore, it may be prudent to look at acquisitions or to develop its aluminium, coal, copper and gold operations. This would reduce Rio Tinto's risk profile in my opinion.
Outlook
Rio Tinto is not a single play commodity, but its reliance on iron ore makes it highly susceptible to a fall in the price of the commodity. The outlook for iron ore is relatively downbeat and even though Rio Tinto has a low cost curve and sound finances, in my view now is not the right time to buy it.
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