Last week was a big one for Rio Tinto (NYSE:RIO) as the Anglo-Australian miner sealed a major iron ore development project in Africa. While the outlook for iron ore prices isn't bullish, the addition of a low-cost, high-quality mine will certainly boost Rio's portfolio.
Rio plans to bring in outside investors to build the required infrastructure related to the project. Even after that, however, the company will have to make substantial investments to develop the mine. While the mine will create value for shareholders in the long term, it will hamper Rio's ability to boost shareholder returns in the medium term.
Rio seals the deal
Rio Tinto announced last week that it signed the investment framework for Blocks 3 and 4 of Simandou iron ore project in Guinea. The investment framework was signed by Rio Tinto, Chinese state metals company Chinalco, the Government of Guinea, and the International Finance Corporation (IFC). Rio said in a press release that the signing marks a major milestone and provides the legal and commercial foundation for the project.
This came after a major delay. In 2008, then-President of Guinea Lansana Conte had rather controversially awarded half of the mining rights to the Simandou iron ore deposit to BSG Resources, which later sold a 51% stake in the venture to Vale (NYSE:VALE). The Guinean government had accused Rio of moving too slowly on the project in 2008. However, in 2011, Rio settled its differences and is now looking to develop the southern half of the iron ore project.
The Guinean government has also cancelled BSG Resources and Vale's mining rights to the northern half of the project, which was confiscated from Rio. As I had discussed in a previous article, the Guinean government decided to cancel the mining rights based on the recommendations of a technical committee that accused BSG Resources of obtaining the mining rights through alleged corruption. Rio is also seeking compensation from Vale and BSG Resources for the billions it says it lost due to the actions of the two companies.
Meanwhile, the company has taken a major step forward with regards to the southern half of the project. The Guinean government is expected to submit the investment framework signed by the concerned parties for consideration of the Guinean National Assembly. Once the framework is ratified by the National Assembly, Rio and its partners in the project will finalize a Bankable Feasibility Study. The study, which is expected to be finalized within one year of the ratification from the Guinean National Assembly, will have all the details on the cost related to the project as well as the development timeline.
Rio could struggle to boost shareholder returns
The Simandou iron ore project will be huge for the economy of Guinea. The project will not only require the development of the mine but also the building of the necessary infrastructure to bring the iron ore to the seaborne market. The infrastructure that is required to be built includes a 650 km railway and deepwater port infrastructure.
The investment required to develop the mine and build the infrastructure is expected to be around $20 billion. Mining giants such as Rio and its Australian rival BHP Billiton (NYSE:BHP) have plans to cut their capital expenditures in the coming years, but Rio is still moving forward with a major project like Simandou. The company is also moving forward with the project despite the bearish outlook for seaborne iron ore market due to an expected supply glut in the coming years.
The main reason that Rio Tinto is pushing forward with such a huge project is the fact that Simandou is one of the world's largest untapped, high-grade resources of iron ore. Even in a low price environment, such a project will be of huge value to Rio Tinto. The main challenge will be securing funding.
Rio said that it is looking for investors who will finance, build, and own the required infrastructure for the project. By bringing in outside investors, Rio Tinto will be able to reduce its exposure to the project. The company could see interest from private equity firms, which have lately been looking at the mining sector for possible investment. Private equity firms are also awash with cash at the moment and could be ideal partner for such a project.
Even after bringing in outside investors, Rio Tinto will still have to make significant investment to develop the mine. While Rio is targeting commercial production by 2018, the project could be delayed further. Given the weak outlook for iron ore prices, Rio Tinto is likely to face challenges in boosting returns to shareholders if such a scenario comes to pass, at least in the medium term.
Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.