What Was Rio Tinto Thinking With This $20 Billion Deal?

Does signing a $20 billion iron ore deal at a time when iron ore prices hit multiyear lows sounds crazy to you? This is what Rio Tinto (NYSE: RIO  ) and Chinalco (NYSE: ACH  ) have done. These companies signed the investment framework for the southern part of the Simandou project in Guinea. Rio Tinto will have a 46.6% stake in the project, while Chinalco will own a 41.3% stake.

Simandou will take years to develop...
The project was already in the news when Rio Tinto decided to sue Vale (NYSE: VALE  ) and BSG Resources at the end of April. Rio Tinto accused Vale and BSG Resources of conspiring to strip Rio Tinto of the northern half of Simandou. Whatever the outcome of what could be a lengthy legal battle, the dispute did not prevent Rio Tinto from developing the southern part of the project.

Simandou is an iron ore deposit of a huge size, which could totally change the economic situation in Guinea. Meanwhile, the supply of ore from Simandou would surely affect global iron ore pricing. However, the key point to notice is that the project will take a long time to develop.

First, investors will work on the bankable feasibility study for the project. This part alone is estimated to last a year. One of the main challenges of the Simandou project will be to build the railroad that connects Simandou with Guinea's capital city, Conakry, which will be the export port for the ore. The railroad goes through the whole country, and funding its construction is a challenge in and of itself.

...which means it puts no near-term pressure on iron ore prices
Thus, we probably should not expect any ore from Simandou in this decade. This means that the project will not pressure iron ore prices in the medium term. However, Simandou will surely affect prices in the long term. This means that weaker iron ore producers have about five years to drive costs down and prepare to compete with Simandou ore.

In current conditions, producers with mines in cost-efficient regions like Australia and Brazil have an advantage. This is why Rio Tinto, BHP Billiton, and Vale continue to grow their production and market share. The Simandou project highlights the fact that big producers will probably get bigger while smaller players could be in danger.

Smaller producers like Cliffs Natural Resources (NYSE: CLF  ) have no funds to battle for projects like Simandou. This means that the cost gap between big players and small players could widen further, pushing smaller players out of the market. Rio Tinto has signed a deal to develop the third and fourth blocks of the project, while the first and the second pieces await developers. This means there will be more ore to come.

Bottom line
Simandou is a good long-term investment for Rio Tinto. Despite iron ore price weakness, Rio Tinto continues to generate healthy cash flow that allows it to pay a dividend that currently yields 4%. Thus, the company could easily afford to spend money on this huge undertaking. Meanwhile, the start of the Simandou project is a warning sign for smaller players that have higher costs. As big producers continue to flood the market with cheap ore, the clock is ticking for weaker ones.

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Vladimir Zernov

Vladimir Zernov believes that fundamental analysis works best with energy and materials stocks and covers them on Motley Fool.

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