26th Nov 2007 07:01
Rio Tinto PLC26 November 2007 Date: 26 November 2007 Ref: PR582g Outlook for metals and minerals - Investor seminar The following paper from Rio Tinto chief economist Vivek Tulpule has been issuedtoday to coincide with the Rio Tinto Investor seminar. Executive summary • Commodity markets are entering a fifth straight year of growth withmineral and metal prices at levels well above their long term average and inmany cases above levels at the start of this year. • Firm global economic activity led by China is expected to supportstrong increases in demand for most metals and minerals over 2008 and 2009. • With low stocks and a likely continuation of supply side difficulties,most commodity prices are expected to remain well above their long run trendover the short and medium term. • It is too early to suggest that the current price cycle has peakedacross the range of commodities. • While the central case is positive, we are mindful of the short termrisks associated with the predicted slowdown in the US economy. o But, it is important to recognise that the United States is now significantly less important in world commodity demand than it was just five years ago. o Additionally our analysis suggests that even a sharp slowing in the US economy would have only a small impact on Chinese and Indian economic growth and consequent demand for commodities. • Viewed from a longer run perspective recent history and the IMF'sforecasts suggest that we are currently going through a period of global growthnot seen since the period of fast growth and reconstruction in OECD economiesfollowing World War 2. • Specifically, there has been a structural shift favouring rapid growthin developing countries with large populations such as China and India. Growthin these economies will be resource intensive as they industrialise andurbanise. • The implications for commodity markets are nothing short of profound.Projections for iron ore, aluminium and copper suggest that demand could doubleand even triple over the next 25 years. • In time production can be expected to expand to meet faster growth indemand at more sustainable prices. But that pricing environment is expected tobe significantly stronger than would be implied by historical trends. o It is expected that prices of many minerals and metals will remain elevated above trend for longer than has been the case in the past because of constraints on the speed with which production capacity can be expanded over the next few years. o Also most prices are expected to assume significantly higher average levels over the very long run than has been the case historically due to structural increases in industry costs. • We present case studies relating to markets for aluminium, copper andiron ore - three commodities that are expected to be drivers of theindustrialisation and urbanisation process in developing countries. Iron ore o Substantial growth is expected in the demand for iron ore reflecting expected strong growth in steel demand related to the processes of ongoing industrialisation and urbanisation in the developing world. o Reflecting the current tight market spot prices have risen sharply over the last few months with Indian ores currently selling in China at around $190/tonne double their price at the beginning of 2007. Australian and Brazilian ores are selling at a substantial discount to this spot rate given current freight rates. o A substantial amount of high cost production will be required to meet growing demand over the long term. This strongly suggests the possibility of higher long run prices & higher margins for traditional lower cost producers. Aluminium o Prices are currently in the range of $2450-2550/t - levels supported by industry cost structures. o Aluminium consumption has grown the fastest of all non-ferrous metals over the last 5 years and is forecast to grow rapidly over the next 20 years. o There has been enormous recent growth in Chinese consumption and production but aluminium has benefited from increasing intensity in many other regions including the OECD. o Constraints on China's domestic bauxite production suggest that the country's massive investment in aluminium capacity will remain reliant on imported bauxite. This combined with China's high power cost environment mean that Chinese aluminium capacity will continue to be high cost on a global scale. o Additionally, Chinese production will also be disadvantaged by a stronger currency as the RMB edges toward fair value over time. o The implied increase in the marginal cost of production for alumina and aluminium means that their prices are unlikely to revert to the lower levels implied by historical trends Copper o Reflecting the tight market situation, copper prices are currently in the range of $6400/t-$7000/t - about three times higher than their average level through the 1990s and well above levels achieved in the early part of this decade. o Prices could remain near current levels as long as production growth continues to under-perform against the underlying demand trend creating a need to ration supplies. o Strong Chinese demand growth is expected next year and on the supply side the likelihood of ongoing disruptions and possible constraints on the availability of sulphuric acid affecting SxEw operations are issues. o The importance of investment funds in exchange traded commodity markets means that large price movements could take place on the back of commodity specific speculative shifts or broader shifts in investor sentiment - well in advance of any fundamental change in physical markets. o Looking to the long run, strong demand growth prospects are based on the expected resource intensive development of economies such as China and associated investment in power distribution networks and other infrastructure. o On balance, we believe that, as for many other commodities, there has been a structural shift in copper costs supporting the expectation of significantly higher long run prices than would be implied by historical trends. A fundamental shift toward fast and resource intensive growth As 2007 draws to a close, resource markets are entering a fifth straight year ofcyclical strength with virtually all minerals and metals prices at levelssignificantly above their long run historical trends and in many cases abovestart of year levels. Looking forward, global GDP growth is expected to be firm in 2008 and 2009 withrapid growth in China and other developing countries expected to reduce any dragfrom slower growth in OECD countries. Such conditions should create a basis forcontinued strong underlying commodity demand over the medium term. At the sametime, growth in production for a number of commodities is expected to remainrelatively constrained. In this context, it is entirely possible that somecommodity prices may not have reached their cyclical peaks as yet. Indeed, illustrating the significance of current commodity market developmentsin a historical context, if as expected, most prices remain well above trendover 2008 and 2009 then prices will have been above trend for 6 years. Thiswould be a 3-in-100 year event for many commodities. Viewed in a broader setting, the current strength in most resource markets canbe seen as the result of a fundamental shift in economic forces that is leadingto rapid growth in developing economies with large populations. For example,recent history and the International Monetary Fund's projections for futuregrowth would suggest that we are currently going through a period of globalgrowth not seen since the period of rapid economic development andreconstruction that followed the Second World War. China and India provide the most significant recent examples of the currentgrowth phenomenon but they are not alone. For instance, many countries in theMiddle East and ASEAN are also on fast growth paths. In such economies growthtends to be resource intensive. In particular, the processes of urbanization andinfrastructure development that accompany early-mid stage productivity growthand industrial development require increasing utilisation of resources such assteel (and therefore raw materials such as iron ore), aluminium, copper andenergy. At a global level such a resource intensive development pattern isexpected to persist for at least another two decades leading to sustained strongglobal demand growth for many commodities. Prices are determined by both demand and supply and by its nature minerals andmetals production can be difficult to accelerate. But accelerating production incyclically high markets can also be very profitable causing a 'rush' to meetdemand. The current 'rush' has manifested itself in a number of forms including:increasing construction costs and project delays; higher levels of disruption asexisting production systems are stretched; higher average production costs dueto labour and other input cost increases; and higher industry marginal costs asincreasingly expensive production is drawn in to meet demand. In time, it is expected that sufficient commodity supply growth will be inducedto cause prices to revert down toward more sustainable long-run levels. But thedemand and supply phenomena just described suggest that it will most likely takelonger for commodity prices to return to long-run levels than would have beenthe case if historical reversion rates had applied. At the same time long-runprices and in some instances margins are expected to be significantly higherthan would be implied by historical trends. Medium term expectations are for strong global GDP growth Against a backdrop of record high oil prices, a rapidly slowing US housingmarket and a credit crunch precipitated by the US sub-prime mortgage crisis, theIMF is nevertheless projecting global GDP growth in 2008 of about 4.8 per cent(in PPP terms)1. This projection accounts for slowing growth in advancedeconomies but relatively fast growth in the developing world. In 2009 a recoveryin activity in advanced economies and continued strong growth in developingeconomies are projected to generate global growth of around 5 per cent1. Viewedin a historical context such growth rates are high and therefore provide apositive setting for underlying commodity demand in the medium term. China's GDP has continued to surge, growing at 11.5 per cent (y-o-y) in thefirst three quarters of 2007. In this period industrial production grew by about18 per cent, nominal fixed asset investment grew by about 26 per cent and thetrade surplus soared to about US$200bn. At the same time inflationary pressures,mainly related to food and energy prices, have been increasing with consumer andproducer price inflation in October at 6.5 per cent and 3.2 per centrespectively. In this setting the government has introduced measures to restrainliquidity. But even with this tightening, GDP is expected to grow rapidly atbetween 10 per cent and 11 per cent in 2008 and around 10 per cent in 2009 basedon strong domestic demand and a strong but moderating contribution from nettrade2. The US economy is expected to grow at around 2 per cent in 2008 as residentialconstruction continues to fall and private consumption growth slows. On theother hand, a weaker dollar is expected to generate an improved contribution toGDP from trade. In 2009 residential construction is expected to start growingagain and the positive effects of recently lowered interest rates on investmentand disposable incomes should lead to a recovery in economic activity; GDPgrowth in the range of 2.5 per cent to 3 per cent is expected in that year3. Japan's growth has been volatile during 2007. It grew strongly by 0.7 per cent(q-o-q) during Q1, declined by 0.4 per cent in Q2 and then beat analysts'expectations to grow by 0.6 per cent in Q34. The contraction in Q2 was partlyattributable to reduced residential construction resulting from theimplementation of a stricter building code. In 2008 and 2009 steady growth inconsumer demand and a rebound in residential construction are expected to offsetslower net exports to see overall GDP grow at around 2 per cent5. The Indian economy grew by more than 9 per cent in each of the first twoquarters of 2007 and growth of between 8 per cent and 9 per cent is expected in2008 and 20096. Capacity constraints in many parts of the economy are creatinginflationary pressures and in response the Central Bank has tightened monetarypolicy. While this reduced inflation it probably also contributed to reducedindustrial production growth during the second half of this year. Expected limited global economic risk from a further US slowdown Markets have been nervous about the impact of slowing US growth on commoditymarkets and speculation about this has had negative effects on exchange tradedprices. But in terms of commodity demand generally, the importance of the UnitedStates has declined substantially relative to that of China since 2000 and inthe specific case of seaborne iron ore, the US is a negligible marketparticipant. In that context, the key issue for the health of commodity marketsover the medium term is the magnitude of any negative spillover effect from aslowing US economy on economic activity in the rest of the world and China inparticular. One macroeconomic linkage is clear. With slower US private consumption and aweaker currency, US demand for exports from other regions can be expected todecline and its own exports to increase. In terms of GDP accounting, this wouldreduce the net contribution of the United States to aggregate demand in the restof the world. But it is easy to exaggerate the potential flow on effects ofthis possibility on global economic activity including in Asia. For example, modelling suggests that a sharp reduction in US consumption andresidential investment during 2008 to levels consistent with a US recession anda weaker US exchange rate would be expected to reduce Chinese growth by lessthan a percentage point. This would still leave scope for Chinese growth atlevels approaching 10 per cent. For India, the impact of any further slowdown inthe US would be expected to be smaller because of India's more limited exposureto world trade. The modelling captures the likelihood that, governments and central banks incountries affected by any US slow down could boost economic activity throughmonetary and fiscal responses. Some commentators have noted that such economicpump priming would favour construction and infrastructure development, which inturn is likely to be a positive for commodity demand. Moreover shifts in trade flows and policy responses are only part of thepicture. A focus on these aspects alone ignores any shift in financial flowsfavouring countries with better investment prospects. For example modeling basedon a framework that focuses on international financial dynamics suggests thatthe flow on effects of any slowing in US growth could be reduced substantiallyas financial resources shift away from the United States toward other locationsincluding developing Asia. Some commodity specific examples further illustrate the point. Chineseconsumption of steel is believed to be affected only marginally by fluctuationsin external demand as China's steel industry is overwhelmingly focused onmeeting needs from the domestic construction sector. Even in the case of copper, consumption is mostly driven by domesticconstruction and infrastructure development which together account for themajority of China's copper consumption. Exposure to external conditions arisesfrom China's position as a major global supplier of household appliancescontaining copper components. China has also grown its exports ofsemi-fabricated products and copper tubes in recent years, although it remains anet importer of semis. It is difficult to put a precise figure on the amount of copper embodied inChinese trade to the United States. But even if 20 per cent of total Chinesecopper consumption were related to exports and given that the United Statesgenerally accounts for around 20 per cent of China's total merchandise exports,the direct exposure of China's total copper demand growth to any slowing in USeconomic activity would be very limited. Currencies Since the start of this year the US dollar has weakened appreciably against mostother currencies. Recent falls in the greenback have been driven by perceptionsof increased riskiness in US asset returns in the wake of the sub-prime mortgagecrisis; and expectations that the US Federal Reserve may cut interest rates toaddress growth concerns while other central banks may raise rates to combatinflationary pressures. The currencies of many commodity exporting countries have also been affected byupgrades to market expectations about future commodity prices and M&A activity.The Australian dollar has gained about 13 per cent against the US dollar sincethe start of the year. The Chilean Peso has gained about 5 per cent, theBrazilian Real has gained about 16 per cent and the Canadian dollar hasappreciated by about 19 per cent7. Such exchange rate shifts have increasedaverage US dollar production costs for many commodities. But at the same time,US dollar weakness provides support to prices of commodities that aredenominated in US dollars but with large non-US consumption and cost bases. Over time, market based exchange rates are likely to fluctuate on ever-shiftingspeculation about relative interest rate policies and ongoing concerns aboutrisk and structural imbalances and commodity prices in the case of largecommodity exporters. In the case of managed currencies, policy and economicpressures on governments or the emergence of unsustainable foreign exchangeflows will have the greatest influence on outcomes. Future rates of appreciationin the Chinese RMB are of special importance for commodity markets. Chinese RMB expected to continue to strengthen providing a basis for higher longrun prices A range of empirical analyses and the evidence of burgeoning trade surpluses andforeign exchange reserves suggest that the RMB is significantly undervalued. Theextent of possible undervaluation is shown in the following chart based onresearch commissioned by Rio Tinto. The straight line labeled 'Fair Value' showsa statistically determined relationship between real exchange rates and percapita incomes. This empirical analysis backs the theoretical argument (known asthe Balassa Samuelson effect) that as developing countries become richer theirreal exchange rates can be expected to strengthen relative to those of therichest countries. The Chinese real exchange rate has been and remains below theestimated fair value line suggesting substantial scope for ongoing revaluation. The Chinese authorities have progressively allowed the currency to appreciate innominal terms against the US dollar. Pressure on the RMB to strengthen furtheris expected to continue, both to address political frictions associated with thetrade surplus and constraints on monetary policy associated with a managedcurrency. Importantly this process of revaluation has been increasing the US dollar costsincurred by trade exposed industries including metals and minerals producers. Inaluminium and iron ore Chinese producers are already among the highest costproducers in the industry and therefore any currency appreciation would tend toincrease marginal industry costs for those commodities over time. In turn, thiscost increase provides a basis for higher global prices. Long run economic developments and implications for commodity markets Long Run Growth and Development Entering a New Elevated Phase It is important to reiterate that the IMF's growth projections for 2008 and 2009are high when viewed in a historical context. This results from an expectedstructural shift (rather than cyclical move) in global economic activity basedon the ongoing economic emergence of China and other developing economies suchas India. Indeed, the expected shift would take world growth to levels not seensince the period of rapid growth and reconstruction in OECD countries just afterthe Second World War. The longer term implications of this shift for commoditymarkets are potentially profound. Our revised analysis of longer run Chinese growth prospects suggests that GDPgrowth can be expected to average levels approaching 9 per cent per annum in theperiod to 2015 providing a sustained basis for strong commodity demand growth.In a similar vein, a recent study carried out by the Development Research Centreunder China's State Council concluded that China's industrialization stage willlast into the 2020's with potential GDP growth rate at around 10 per cent in theperiod to 2015 and 8 per cent from 2015 to 2020. A study by Australian NationalUniversity academics, Garnaut and Song, suggests that China is reaching a 'turning point' in its growth creating potential for highly resource intensivegrowth in excess of 10 per cent over the next two decades. Indian growth has lagged behind China's despite both countries having hadsimilar per capita incomes in 1980. In more recent years Indian growth hasaccelerated and importantly it has become less variable. Studies by Rio Tintosuggest that India has the potential to grow at a sustained rate of around 10per cent for at least a decade if key economic reforms are undertaken. Studiesby banking research groups produce similar results with long run growthpotential estimated to be in the 8 per cent-10 per cent range8. Most of thisresearch points out that continued reforms that free up the ability of Indianindustry to respond to price signals remain crucial both to allow more rapidallocation of resources to their most profitable uses and reduce inflationaryrisks. In India's case it is arguable that the turning point favouring highlyresource intensive growth, identified for China by Garnaut and Song, is still tobe reached. Commodity demand expected to grow strongly The shift toward faster and more resource intensive global growth led bydeveloping countries has led to strong rises in commodity demand over recentyears. But per capita consumption remains relatively low in those countriessuggesting scope for strong growth well into the future. For example, whileChina accounted for 60-90 per cent of the increase in global demand for steel,aluminium and copper between 2000 and 2006 its per capita consumption of thosemetals remains well below that of many OECD countries9. For example in 2006Chinese per capita steel consumption was about 60 per cent of that in the OECDaverage while its per capita copper and aluminium consumption was at aroundone-third of OECD levels. The implication is that Chinese demand for thesecommodities - and associated raw material inputs - has substantial scope tocontinue to grow rapidly for some time. Indian per capita consumption is afraction even of China's consumption, suggesting scope for rapid sustaineddemand growth over the longer run. Empirical analysis based on historical patterns of commodity consumption anddifferences in commodity consumption between countries shows a relationshipbetween per capita incomes and commodity consumption - typically known as 'commodity S-curves'. The S-curves suggest that as incomes grow per capitaconsumption of commodities increases. At first growth is more rapid as economiesindustrialise, build urban environments and commercial infrastructure and thengrowth slows for rich countries as consumption per head approaches saturation.Such S-curves are shown for a range of commodities in the graph below. The analysis shows that per capita consumption of aluminium, copper and steelmaking raw materials tend to pick up at a relatively early stage of industrialdevelopment. For aluminium the empirical analysis also suggests that demand indeveloped countries has not yet achieved saturation implying scope for morebroadly based future per capita global consumption growth. For commodities suchas iron ore and coking coal it is important to recognise that the S curves arefor total consumption and not for consumption of seaborne material. So, forcountries in which domestic production of raw materials is constrained, growthprospects for imports of seaborne materials may be greater than for demand inaggregate. The chart shows that the largest proportion of the world's population has lowaverage per capita rates of commodity consumption consistent with relatively lowincomes. As per capita incomes grow larger numbers of people will consumeincreasing commodity volumes and aggregate global consumption of commodities canbe expected to rise at a fast rate. For example, based on the S-curve analysisand assuming a plausible positive scenario for global growth over the next 2 to3 decades, the seaborne iron ore market could triple in size relative to today'slevel. Of course the analysis does not suggest that demand will increase at a steadyrate over time. Macroeconomic cyclicality along with stocking and destockingpatterns can be expected to play major roles in determining demand outcomes fordifferent commodities in any given year. For example, in China's case withvirtually all sectors of the economy growing rapidly, there is a chance thatdevelopments in some parts of the economy could move out of phase withdevelopments in other parts. This suggests a possibility that at times economicimbalances could emerge, generating cycles of strong growth and capacitybuilding followed by periods of slower growth, catch up and consolidation. Theimplication is that Chinese growth and associated commodity demand growth can beexpected to have a cyclical pattern over time. Supplies are stretched and capacity expansions have been delayed The supply side of the mining industry continues to face challenges in itsresponse to fast demand growth. These challenges have been exacerbated by aprolonged period of underinvestment throughout the sector due to slow demand andlow prices during the 1990's and into the early 2000's. As a result, theindustry entered the current cycle with reduced capabilities at all stages ofproject development, from exploration through to construction and operations. Inthis setting, the industry has become increasingly stretched in its attempt tomeet stronger demand and in many cases there is little slack in the system tocompensate for disruptions such as those related to events of nature anddowntime for maintenance. There are few signs that constraints faced by the supply side are easing in theshort term - as indicated for example by shipping freight rates which havereached new record levels in recent months. Operating and capital costs havecontinued to rise in 2007 and supply has once again underperformed significantlyespecially in the copper market. Some of the supply challenges are medium term in nature. These are typicallyrelated to: increased demand for materials and equipment, leading to higherinput costs and longer lead times; and bottlenecks in supporting infrastructure(ports, rail and shipping). Other constraints will take much longer to address. First, the industry ismoving increasingly toward the development of resources that in the past wereeither considered to be too complex or low-grade or in regions with high countryrisks and poor infrastructure. This is presenting challenges to miningcompanies not only because new skills and technologies are required to developthose resources, but also because of the increased capital intensity anddelivery risks associated with many such projects. Second, the industry and itssuppliers and contractors are facing acute shortages in the labour market -especially in relation to skilled professionals such as experienced miningengineers with project management experience - leading to increased projectcosts and delays. Importantly the mining industry is not alone in the struggle to access materialand human resources. The upstream and downstream oil sector as well as thechemical industry have also stepped up their capital spending plans in recentyears and are competing for similar parts and equipment, construction workersand the services of EPCM contractors. The competitive environment for suchinputs has led to capital cost escalation for mining projects and longer leadtimes to deliver new capacity. As a result, the commodity prices required toinduce development of future resources are likely to face upward pressure. Natural resources constraints facing the mining industry extend to its access tosupporting resources such as energy and water. In this context, environmentalconsiderations in the development of new projects present a key set of long-termresource related challenges. Additionally, it is becoming apparent thatregulatory approvals are becoming an increasingly significant barrier to rapidsupply expansion. Such constraints are likely to persist and perhaps become moresignificant over the longer term. Commodity case studies We present case studies relating to markets for aluminium, copper and iron ore -three commodities that are expected to be drivers of the industrialisation andurbanisation process in developing countries. Iron ore Current pressures in the iron ore market are intense as reflected by spotprices, which have increased sharply over the last several months. Spot Indianores are currently selling in China at now at around $190/tonne, double theirprice at the start of the year. After taking into account current freightrates, Australian fine ores sold at benchmark prices (of around $50/tonne) tradeat a substantial discount to these spot prices. Brazilian ores, which havesignificantly higher transportation costs to the growing Asian market, sell at alower but still significant discount10. On the demand side, steel production has grown rapidly leading to strong growthin iron ore trade. Chinese crude steel production has continued to rise by over18 per cent y-o-y despite the levying of export taxes11. While these taxes andthe weaker US economy have discouraged exports, this has been more than offsetby renewed strength in domestic demand. Evidence of this is suggested bydomestic Chinese steel prices which reached a new high in mid-October. Strong demand for iron ore is not limited to China, however. Annual Japanesecrude steel output this year is expected to hit a new record level for the firsttime in 33 years and the German Steel Federation has recently raised itsforecast of domestic steel production for this year. While North American steelproducers have cut back output this has little impact on the seaborne iron oremarket as nearly all domestic production relies on either domestic ores orscrap. Increases in demand for iron ore have continued to outpace the ability of lowcost producers to add additional supply. Over the first three quarters of theyear Chinese iron ore imports rose by 15 per cent12 - less than the rise insteel production This means that in high-grade equivalent terms the amount ofChinese iron ore production required to meet domestic demand is expected to bearound 350 million tonnes this year. Much of this is produced at a relativelyhigh cost. Chinese costs (in US dollar terms) have also been affected by astrengthening RMB and this pressure is expected to persist while the RMB remainsundervalued. At the same time, as well as having to mine lower grade ores, thereis an increasing reliance on new more remote and therefore more expensive supplyfrom the far north eastern parts of China. Costs of Indian ores have alsoincreased due to new taxes and a progressively strengthening rupee. There hasonly been limited progress on the major infrastructure investments required inIndia to make its exports more competitive and at the same time exports competeagainst strongly rising domestic demand for ores. Most importantly theescalation in freight rates has substantially increased the cost of landing orein Asian markets from all destinations. The overall implication is that currenthigh prices have, in all probability, been supported by a rising and steepeningindustry marginal cost structure. Over the longer run, continued strong growth in demand for steel in developingcountries and developed parts of the Middle East is expected to result insubstantial growth in seaborne iron ore trade over the next two decades. Giventhe large volumes of high cost production currently in operation andexpectations for continued demand growth, any reversion of prices to lower longrun levels can be expected to take place over an extended period. Additionallyit is expected that a substantial amount of high cost production from China andIndia will continue to be required to meet growing demand over the long term.This strongly suggests the possibility of higher long run prices and margins forthe traditional lower cost producers. Aluminium Spot aluminium prices have moderated by about 10 per cent since the middle of2007 and are currently moving in the range of $2450/t-$2550/t13. Prices ataround these levels are supported by production costs at the highest costsmelters. Forward prices have increased in relation to spot prices reflecting amarket expectation that production with high marginal costs could be required tomeet demand for primary metal over the medium term. Aluminium has experienced the fastest consumption growth of all non-ferrousmetals over the past five years and it is forecast to continue to enjoy one ofthe most rapid growth profiles over the next two of decades. CRU projectsconsumption to grow by more than 140 per cent over the period to 203014. Onereason for the recent growth is that China's economic development is highlyaluminium intensive. But at the same time there have been worldwide gains inintensity of use and favorable substitution across a wide range of applications. The strong and sustained growth in aluminium demand is starting to stretch theresource base that has been the foundation of the development of the aluminiumindustry - large-scale good-quality bauxite deposits and competitively pricedstranded energy. In the case of bauxite the escalation in demand for aluminium is being metincreasingly from high cost and low-scale bauxite deposits in China andopportunistic mining operations in Indonesia. Such sources of supply areunlikely to provide a long term solution for the industry's rapidly growingbauxite needs and have already led to stronger prices for traded ore. Thisimplies that significant investment in new large scale bauxite mines are likelyto be required if the industry is to meet demand projections. Meanwhile, high energy prices combined with a greater integration betweenregional energy markets through the development of LNG and gas-to-liquidsprojects could increase the costs of power available to greenfield smeltersaround the world. Together with a likely growing trend towards the introductionof pricing mechanisms or tax regimes for carbon emissions, sustainable strandedhydropower sources have become more valuable. This in turn may increase thevalue of existing aluminium capacity linked to such power sources. In the context of growing demand and constrained supply, the long run pricingenvironment for the industry will be heavily influenced by the evolution ofcosts. Turning first to alumina, refineries relying on imported bauxitesupplies, such as in Europe and the US Gulf coast, have traditionally occupiedthe top-end of the alumina cost curve. High energy prices and rising deliveredbauxite costs have increased the competitive disadvantage of these refineriesover the past five years. The Chinese industry is currently adding significantnon-integrated alumina capacity drawing on its capital cost advantage. Theserefineries are rapidly joining US and European alumina refineries toward the topof the cost curve. The resulting increase in the marginal cost of productionmeans that alumina prices are unlikely to revert to the lower levels implied bylong run historical trends even if some higher cost integrated capacity iseventually replaced by lower cost production. As with alumina, in the case of aluminium new Chinese smelters are fundamentallychanging the shape of the industry cost curve. The rapid increase in Chinesesmelting capacity since the start of this decade reflects the moderate barriersto entry in building smelters in China due to low capital costs and short buildtimes. However, this new capacity has come in at the top-end of the operatingcost curve mainly reflecting relatively high power costs. Consequently, theindustry aluminium cost curve has shifted up since 2003 and become steeper. Thishas provided a new significantly higher base for prices. A key point to note is that the gradual appreciation of the Chinese currencyshould also translate into higher US dollar production costs for Chinesesmelters - all other things being equal. To illustrate this point, the effect ofa further 10 per cent appreciation of the Chinese RMB on the aluminium costcurve is shown on the chart above. With Chinese smelters predominantly in thethird and fourth quartiles, the top end of the curve would shift up in such ascenario creating an even higher basis for aluminium prices and higher marginsfor smelters in the lower cost quartiles. Copper Copper stocks have been at critically low levels since a surge in consumption in2004 depleted available inventories. From that point, stocks have beenconstrained by supply's inability to match a stronger underlying demand growthtrend related mainly to Chinese growth. Reflecting the tight market situation,copper prices are currently moving in the range of $6400/t-$7000/t15 or aboutthree times higher than their average level through the 1990s and well abovelevels achieved in the early part of this decade. Unlike for iron ore and aluminium, the scope for opportunistic and high-costsources of supplies to help bridge supply shortages has been limited for copper.Current prices are therefore significantly above marginal costs of supply. Shortterm copper prices are instead supported by the need to induce those with theleast 'willingness to pay' for copper to reduce their consumption. In thiscontext most of the switch away from copper has so far occurred in the plumbingsector to the advantage of plastics. This means that prices could remain nearcurrent levels as long as production growth continues to under-perform againstthe underlying demand trend creating a need to ration supplies. In terms of demand, most analysts are projecting flat copper consumption outsideof China in 2007. But within China copper consumption growth is projected togrow by 15 per cent this year. Calculations of apparent demand are pointing togrowth well in excess of that number, although this is thought to reflect thereversal of a destocking phase in China during 2006. Overall global demand isexpected to record its strongest growth since 2004, rising this year by about3.5-4.0 per cent16. Looking forward, even with a projection of high underlyingaverage demand growth in China, demand for material can be expected to fluctuateunpredictably over periods of months on stocking and destocking cyclesgenerating price volatility. On the supply side copper miners have faced many of the challenges andbottlenecks discussed earlier. Strikes and unforeseen disruptions from weatherrelated events and accidents have also affected the performance of existingcopper mines. It is estimated by Brook Hunt that actual global mine output overthe past three years has underperformed market expectations by a cumulative 2.5to 3 million tonnes of copper. This is equivalent to annual losses of 4 percent to 6 per cent which compare with losses in normal years closer to 2 percent. The medium term outlook for copper will be highly dependent on whetherdisruptions continue to run at high levels. Third quarter production reportsfrom copper mining companies suggest that this remains an ongoing issue. Inaddition recent reports have pointed to potential shortages of sulphuric acidwhich could constrain SxEw operations in the short term. This source of supplyhas accounted for a high proportion of primary production growth over the pasttwo years. The influence of investment funds activity could also be a factor affectingmedium term prices in the copper market. In particular, some analysts aresuggesting that additional demand associated with long only funds means thatstocks levels associated with a market in equilibrium will need to be higherthan in the past. In any case, the likely continued importance of investmentfunds in exchange traded commodity markets means that large price movementscould take place on the back of commodity specific speculative shifts or broadershifts in investor sentiment - well in advance of any fundamental change inphysical markets. Looking to the long run, CRU projects that copper demand will more than doubleover the next 25 years. Growth prospects are based on the expected resourceintensive development of economies such as China and the associated investmentin power distribution networks and other infrastructure. Additionally, in ahigh-energy price and carbon conscious world copper can be expected to benefitfrom any global drive for increased energy efficiencies and any shift towardsthe development of local distribution networks around sources of renewableenergy. Ultimately, the industry should be able to surmount bottlenecks in equipment andsupplies. However, some of the supply challenges are likely to be of alonger-term nature. These include declining ore grades, an increasing shifttowards underground operations and the need for the industry to access anddevelop deposits in countries with higher risk profiles such as the DRC.Meanwhile upward pressure on capital costs for copper projects is likely toremain. This suggests that future long run prices and margins may be sustainableat levels well above long run historical averages without encouraging excesscapacity. Historically copper prices have tended to trend towards the industry's marginalcash cost of production. But reflecting the cointegrated nature of costs andprices, cash costs have continued to move up driven by higher labour rates andbonuses, increased royalty payments, and stronger prices for supplies, servicesand energy. Exchange rate changes have also been significant in key coppermining regions, exacerbating the upward pressure on cost. Overall, costincreases have been felt more strongly at the margin and we estimate 9th decilecosts to be back near or even above levels last seen at the start of theprevious decade. While some of the recent cost pressures are likely to subsidein the longer term, we believe that, as for many other commodities, a structuralshift in the copper cost curve has occurred supporting an expectation ofsignificantly higher long run prices than would be implied by historical trends. Continued firm global economic activity led by rapid resource intensive growthin China is expected to support strong increases in demand for most metals andminerals over 2008 and 2009. At the same time with low stocks and a likelycontinuation of supply side difficulties, most commodity prices can be expectedto average well above their long run trend over this period. It is too early tosuggest that the price cycle has peaked across the range of commodities. While the central case is positive, it is important to remain mindful ofmacro-economic risks especially relating to US housing and credit markets.However it is also important not to exaggerate these risks as our modellingsuggests that they may not have a significant impact on the developing economiesthat have been the growth engines of commodity demand. It is also important tokeep in mind that price movements from month to month will be influenced bystocking and destocking and investment funds' activities that may be onlyindirectly related to economic growth. Over the longer run strong resource intensive growth from China, India and otherdeveloping countries should continue to provide momentum to commodity demand.Indeed, recent history and the IMF's projections for future growth would suggestthat we are currently going through a period of global growth not seen since theperiod of fast growth and reconstruction in OECD economies following the SecondWorld War. The implications for commodity markets are profound. In time production can be expected to expand to meet faster growth in demand atmore sustainable prices. However, it is expected that prices of many mineralsand metals will remain elevated above trend for longer than has been the case inthe past because of constraints on the speed with which production capacity canbe expanded over the next few years. Also most prices are likely to assumehigher levels than has been the case historically due to structural increases inindustry marginal costs. Sources: 1: IMF World Economic Outlook, October 2007 2: Global Insight, Interim China forecasts, November 2007 3: Global Insight, Interim USA forecasts, November 2007 4: Cabinet Office, Government of Japan for historical quarterly GDP growthestimates, Development of real GDP, November 2007 5: Global Insight, Interim Japan forecasts, November 2007 6: Global Insight, Interim India forecasts, November 2007 7: Data downloaded from Ecowin database, November 2007 8: Lehman Brothers, India: Everything to play for, October 2007; Goldman Sachs,India's Rising Growth Potential, January 2007 9: References to steel from IISI, World Steel in Figures, September 2007; forreferences to aluminium CRU The Long Term Outlook for Aluminium, 2007 Edition;for references to copper CRU Copper Quarterly, October 2007 10: CCCMC and Rio Tinto analysis (Indian exports), Mysteel, CUSTEEL and RioTinto analysis (domestic concentrate), benchmark prices and Clarksonspot freightrates (Australia and Brazil). 11: IISI Media Release, November 2007 12: CRU Steelmaking raw materials Monitor, November 2007 13: LME data downloaded from Ecowin database, November 2007 14: CRU The Long Term Outlook for Aluminium, 2007 Edition 15: LME data downloaded from Ecowin database, November 2007 16: CRU Copper Quarterly, October 2007 About Rio Tinto Rio Tinto is a leading international mining group headquartered in the UK,combining Rio Tinto plc, a London listed company, and Rio Tinto Limited, whichis listed on the Australian Securities Exchange. Rio Tinto's business is finding, mining, and processing mineral resources. Majorproducts are aluminium, copper, diamonds, energy (coal and uranium), gold,industrial minerals (borax, titanium dioxide, salt, talc) and iron ore.Activities span the world but are strongly represented in Australia and NorthAmerica with significant businesses in South America, Asia, Europe and southernAfrica. For further information, please contact: Media Relations, London Media Relations, Australia Christina Mills Ian HeadOffice: +44 (0) 20 8080 1306 Office: +61 (0) 3 9283 3620Mobile: +44 (0) 7825 275 605 Mobile: +61 (0) 408 360 101 Nick Cobban Amanda BuckleyOffice: +44 (0) 20 8080 1305 Office: +61 (0) 3 9283 3627Mobile: +44 (0) 7920 041 003 Mobile: +61 (0) 419 801 349 Media Relations, US Media Relations, Canada Nancy Ives Bryan TuckerMobile: +1 619 540 3751 Office: +1 514 848 8511 Investor Relations, London Investor Relations, Australia Nigel Jones Dave SkinnerOffice: +44 (0) 20 7753 2401 Office: +61 (0) 3 9283 3628Mobile: +44 (0) 7917 227 365 Mobile: +61 (0) 408 335 309 Investor Relations, North AmericaDavid OvingtonOffice: +44 (0) 20 7753 2326 Jason CombesMobile: +44 (0) 7920 010 978 Office: +1 (0) 801 685 4535 Mobile: +1 (0) 801 558 2645 Email: [email protected] Email: [email protected] Website: www.riotinto.com High resolution photographs available at: www.newscast.co.uk Forward looking statements This article includes "forward-looking statements". All statements other thanstatements of historical facts included in this article, including, withoutlimitation, any regarding Rio Tinto's financial position, business strategy,plans and objectives of management for future operations (including developmentplans and objectives relating to Rio Tinto's products), are forward-lookingstatements. Such forward-looking statements involve known and unknown risks,uncertainties and other factors which may cause the actual results, performanceor achievements of Rio Tinto, or industry results, to be materially differentfrom any future results, performance or achievements expressed or implied bysuch forward-looking statements. Such forward-looking statements are based on numerous assumptions regarding RioTinto's present and future business strategies and the environment in which RioTinto will operate in the future. Among the important factors that could causeRio Tinto's actual results, performance or achievements to differ materiallyfrom those in the forward-looking statements include, among others, levels ofdemand and market prices, the ability to produce and transport productsprofitably, the impact of foreign currency exchange rates on market prices andoperating costs, operational problems, political uncertainty and economicconditions in relevant areas of the world, the actions of competitors,activities by governmental authorities such as changes in taxation or regulationand such other risk factors identified in Rio Tinto's most recent Annual Reporton Form 20-F filed with the United States Securities and Exchange Commission(the "SEC") or Form 6-Ks furnished to the SEC. Forward-looking statementsshould, therefore, be construed in light of such risk factors and undue relianceshould not be placed on forward-looking statements. These forward-lookingstatements speak only as of the date of this article. Rio Tinto expresslydisclaims any obligation or undertaking (except as required by applicable law,the City Code on Takeovers and Mergers (the "Takeover Code"), the UK ListingRules, the Disclosure and Transparency Rules of the Financial Services Authorityand the Listing Rules of the Australian Securities Exchange) to release publiclyany updates or revisions to any forward-looking statement contained herein toreflect any change in Rio Tinto's expectations with regard thereto or any changein events, conditions or circumstances on which any such statement is based. Nothing in this article should be interpreted to mean that future earnings pershare of Rio Tinto plc or Rio Tinto Limited will necessarily match or exceed itshistorical published earnings per share. Subject to the requirements of the Takeover Code, none of Rio Tinto, any of itsofficers or any person named in this article with their consent or any personinvolved in the preparation of this article makes any representation or warranty(either express or implied) or gives any assurance that the implied values,anticipated results, performance or achievements expressed or implied inforward-looking statements contained in this article will be achieved. This information is provided by RNS The company news service from the London Stock ExchangeRelated Shares:
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