Bottomless pit

Rio Tinto capex cuts won't stop race to the bottom

Rio Tinto is giving to shareholders with one hand and taking away with the other.

The Anglo-Australian mining giant on December 8 said that it would cut capital expenditure by $1.5 billion up to the end of 2016, saving a dollop of cash amid a rout in commodities. Yet that just buys more time for Rio to persist with its risky strategy of boosting output into a falling market to force out higher-cost producers.

Rio's big idea is to use its own low costs to fight a war of attrition with rivals. Yet it has failed to halt the decline in prices for the key commodities it mines. Neither has it succeeded in stopping others from digging the stuff up. Iron ore, which accounts for 42 per cent of Rio's sales, is trading at its lowest level for a decade amid a glut in supply.

Although it is cutting back on new project spending, Rio is still targeting record iron ore production in the region of 340 million tonnes this year. Even though production costs have fallen to around $15 per tonne - well below the current price of $40 - underlying earnings are likely to decline by 15 per cent in 2016, according to a consensus view of 26 analysts.

The company isn't desperate. The weakening Australian dollar, which has fallen 14 per cent against the dollar, will also help to reduce lower local supplier costs in the Pilbara iron ore region where the company is still expanding production. Rio's dividend for this year will barely be covered by its underlying earnings, but is more than twice covered by the company's cash pile.

Further out, the big question is whether Rio's risky bet will pay off. Encouraging lower prices to shut down marginal production only works if rivals behave rationally, which not all do. China's iron ore production fell less than 10 per cent in the year to October 30, even though the price of ore fell 45 per cent over the last year.

The five per cent share price drop on December 8 as Rio cut its dividend suggests investors are not optimistic. A quick rebound in the price of iron ore, copper and aluminum beats pouring cash into a bottomless pit.