The iron ore price has made gains in recent days. This takes its increase in 2016 to over 30%, which could lead many investors to believe that the worst is now over for the steel-making ingredient.
However, in my view the prospects for iron ore miners such as Rio Tinto Limited (ASX: RIO), Fortescue Metals Group Limited (ASX: FMG) and BHP Billiton Limited (ASX: BHP) remain downbeat. Rio Tinto's reliance on iron ore means that it could be hit hard by a falling iron ore price.
A changing industry
A key reason why iron ore faces a challenging outlook is increasing supply. Shipments from Brazil are due to increase by 110 million tons per year to 480 million tons between now and 2020. Similarly, Australian shipments of iron ore are forecast to rise by 100 million tons per annum to 934 million tons in the next four years.
This is due to several new projects coming onstream, such as Vale's S11D project in Brazil. The effect of this is forecast to be an increase in the surplus of iron ore to 56 million tons in 2018 from 20 million tons in the current year. Although the global surplus is forecast to start to shrink in 2018 and will drop to 8 million tons in 2019, between now and then the price of iron ore could fall.
Outlook
Rio Tinto relies on iron ore for 64% of its operating profit. Although the company will benefit through the course of 2016 from an improved iron ore price, it is forecast that iron ore prices will begin to soften as soon as the end of the current calendar year. In my view, this will hurt Rio Tinto's profitability and could cause its share price to fall.
In recent years, Rio Tinto has strengthened its status as a low-cost iron ore miner. It will continue to focus on maintaining its competitive advantage through further cost cutting. For example, it is expected to reduce operating cash costs by US$2 billion in 2016 and 2017. Although this will help to cushion the blow of a lower iron ore price, the scale of the forecast increase in supply means that cost reductions may be insufficient to offset price falls.
A changing business?
Rio Tinto has focused on reducing capital expenditure and paying down its debt pile. The latter was cut by US$1.8 billion in the last six months to US$21.8 billion. This puts Rio Tinto towards the bottom end of its gearing ratio target range of between 20% and 30%. In my view, this provides it with the financial standing to invest in its non-iron ore divisions to improve diversity and reduce its dependence on iron ore.
Ahead of what could be a challenging period for iron ore, a more diverse Rio Tinto could become lower risk and more appealing. However, given its reliance on iron ore and the outlook for its price, I believe that Rio Tinto is a company to avoid. Therefore, long term investors should take a look at these three blue-chips instead.
