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Should you buy Rio Tinto Limited for iron ore price gains?

Pilbara iron ore mine

The last two days have seen the iron ore price rise by 4%. This takes the gain for the steelmaking ingredient to 33% in 2016. In response, shares of iron ore miners Rio Tinto Limited (ASX: RIO), BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG) have moved higher. They are up by 15%, 27% and 162% in 2016.

While confidence across the iron ore sector may be high, in my view iron ore faces a challenging future. Alongside heightened political risk and a bearish outlook for aluminium, I feel that now is not the right time to buy Rio Tinto.

Production forecasts

In 2017, the supply of iron ore is forecast to exceed demand by a greater margin than in 2016. That’s because the two largest seaborne iron ore suppliers, Australia and Brazil, are expected to increase production. The world’s major iron ore producers account for around 80% of the seaborne market. They expect to add upwards of 75 million tonnes next year. This is up from 2016’s 55 million tonnes. The effect of this increase in supply could be a lower iron ore price.

Demand fears

Alongside a planned increase in supply, demand for iron ore could fall. There are concerns in China regarding the growth rate of its property market. It is the biggest driver of commodity demand and has increased at an annualised rate of over 9% in the last year. Therefore, action is being taken to restrict property ownership. This could cause a slowdown in the construction industry and reduce demand for iron ore.

Political risk

Rio Tinto faces an increased level of political risk. That’s because Western Australia National’s leader Brendon Grylls has proposed a mining tax which would increase the so-called production rental fee from $0.25 per tonne to $5 per tonne. Rio Tinto estimates that this would add around $1.5 billion to its annual cost base. It would undo a lot of improvements that Rio Tinto has made to make its business more competitive versus peers. It could also cause a reduction in capital expenditure, which would hurt the company’s long term financial outlook.

Aluminium

Rio Tinto’s financial prospects are also uncertain due to the bearish outlook for aluminium. The base metal contributed 20% of Rio Tinto’s profit in the first half of the 2016 financial year, but its price looks set to fall due to a supply/demand imbalance. Chinese aluminium producers are expected to raise production over the medium term. For example, the world’s largest producer of aluminium by output, Hongqiao, plans to expand production to 6 million tonnes by the end of the year.

Outlook

Rio Tinto faces an uncertain future in my opinion. The prices of iron ore and aluminium could fall and hurt the company’s financial performance. It also faces heightened political risk from a potentially damaging tax change. Therefore, while investor sentiment towards Rio Tinto has improved and boosted its share price, I feel that now is not the right time to buy it.

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Motley Fool contributor Robert Stephens has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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