Deep in the middle of the Gobi Desert, there is a city like many others. There are restaurants, houses, citizens, basketball courts, and enough jobs to go around. It's a civilization in the most unlikely of places, but there's money to be made here in the form of copper.
Welcome to Oyu Tolgoi, Rio Tinto's (NYSE:RIO) newest copper mine, now ready for action and ready to sell to the No. 1 copper consumer: China.
China needs copper, and badly
In 2011, China was a consumer of nearly 8 million metric tons of copper, accounting for 40% of the world's total. This copper is used in everything from electronics to infrastructure. The trend began in 2002, when China supplanted the US as the world's largest copper consumer, despite having a very limited supply of copper ore.
Therefore, China has had to buy scrap copper and build smelting facilities to make it usable. With China's economic growth slowing, it will need copper for transportation and infrastructure reforms to stabilize economic growth, which combine for 62% of China's copper usage. By 2014, it is expected that China will consume nearly 84% of the world's copper, at 9 million metric tons, indicating that copper should see increased demand.
These developments make Rio Tinto's Mongolia mine all the more lucrative. China imported 7% of its copper from Mongolia in 2012, when Oyu Tolgoi was just starting up. By having a mine like that on their doorstep, it would decrease China's reliance on copper from Latin America, particularly Chile.
Mongolian copper's best customer
Whichever operator is closer to China in terms of mining production will stand to benefit the most from China's surging production, and the best situated company is Rio Tinto. This quarter was very significant because the Oyu Tolgoi mine sent its first shipment of copper to China. This output helped push Rio Tinto's mined copper output up by 10% year over year, a significant improvement.
The mine was an expensive proposition, costing $6.2 billion over three years, but according to analysts, it will produce over 450,000 tons of copper annually, valued at $1.4 billion a year at spot price. Rio Tinto owns a 46% stake in the mine, which at full capacity will increase Mongolia's GDP by 30%. The total costs increased unexpectedly to $10 billion, though it should be profitable by 2021, assuming a current copper spot price of roughly $3/pound and continuing demand from China.
Will Chilean copper lose market share?
With this new mine set to make big profits for Rio Tinto, it allows the company to be more competitive against fellow copper big-shot BHP Billiton (NYSE:BHP), which has a 57.5% stake in the Escondida mine in Chile, the world's largest copper mine. This grants access to a mine that produces 152,000 tons of copper per day, valued at $474 million, dwarfing Oyu Tolgoi. However, unlike Rio Tinto, BHP does not have a significant investment in Asian copper mines, even though it has the inside track at Escondida to fill the western hemisphere's copper needs. If China does become more reliant on copper, BHP might need to consider investing in Mongolia.
Freeport likes Asia as well
One option for BHP to tap into China's growing appetite is to look toward Indonesia, where Freeport-McMoRan (NYSE:FCX) collected 158 million tons of copper for sale last quarter. Freeport's net income for the quarter was down $300 million year over year to $482 million, largely due to $5.5 billion in capital expenditures, which shows that the company is looking to bulk up its copper capacity as well as an expansion into Indonesia. The company was able to sell 951 million pounds of copper this quarter, with 158 million coming from Indonesia.
Still, Freeport got 315 million pounds out of competitive South America, thanks in large part to a 51% stake in the El Abru mine in Chile. While it is a tremendous advantage to be in Chile to mine copper, it is an incredibly competitive area, and like BHP-owned Escondida, it is far from China, where the biggest customers of copper will be found for the foreseeable future.
Copper diversity helps Rio Tinto
Looking at these copper companies, it seems evident that Rio Tinto is the more diverse company in terms of holdings and competitive positioning. With Oyu Tolgoi now able to ship copper to China, it gives the Chinese the ability to buy more copper from their northern neighbor and wind down more expensive imports from Latin America. Of course, this doesn't mean that Chile will become a wasteland. China gets over 74% of its copper from Latin America, and unlike manufactured goods, copper producing countries are a product of geography and geology as much as having a strong pro-mining business climate. However, as a percentage, China's reliance on that region will decline as Asian mines churn out more copper.
Striking gold with copper
For long-term investment, Rio Tinto and Freeport would be the best options, but Rio Tinto has a better future in the works. While Freeport reported a stronger profit margin, Rio Tinto is so far the only private company with access to the growing Mongolian copper market and has started shipments to copper-hungry China.
Rio Tinto has the advantage in affordability and value, with a P/E of 8 and a P/B ratio of 1.8, reflecting current profitability problems and positive future outlook, compared to Freeport's P/E of 9 and P/B of 1.4. This makes Rio Tinto a more affordable buy, as investors see value in their Mongolian investments paying off in the long run, as they should barring any unforeseen Chinese crash.
With China needing more and more copper, Rio Tinto will have an advantage in terms of being in Mongolia as well as controlled interests in Latin America, while Freeport has Indonesia and Latin America. Given the trends, Rio Tinto will make a profit in the future if Oyu Tolgoi is the money maker everyone expects it to be, and investors will see the company in the black in the years to come, while Freeport's growth will be more level.