Despite big miner Rio Tinto’s (LSE: RIO) recent share price gains and continuing operational progress, I’m avoiding the firm’s shares. Instead, I’m focusing on three factors that undermine a long-term investment in the firm.
Calling in Doctor Copper
Although Rio Tinto recently earned more than 80% of its profits from producing iron ore the firm has big ideas about expanding its copper operations. In today’s news, Rio Tinto and its partners, the Government of Mongolia and Turquoise Hill Resources, have approved the next stage in the development of the world-class Oyu Tolgoi copper and gold mine in Mongolia.
In a measure of just how long it takes the world of big mining to respond to the outcomes of the supply and demand equation for natural resources, Rio Tinto’s deputy chief executive Jean-Sébastien Jacques said: “Rio Tinto’s partnership with Mongolia began over a decade ago… Today’s investment takes it to another level and will transform Oyu Tolgoi into one of the most significant copper mines globally, unlocking 80% of its value.”
According to the deputy chief, long-term copper fundamentals are strong and the proposed ramp-up in production from Oyu Tolgoi will commence just as many expect copper markets to face a structural deficit.
That’s interesting because one old market saw is that ‘Doctor Copper’ has a PhD in economics due to its apparent ability to predict turning points in the global economy. The argument goes that copper’s widespread applications in many sectors of the economy, such as in electronics, plumbing and the power industry, make demand for copper a reliable leading indicator of economic health. Some believe rising copper prices suggest strong copper demand and hence a growing global economy while declining copper prices may indicate sluggish demand and an imminent economic slowdown.Â
However, the presence of a structural deficit in the copper industry suggests an imbalance such that a shortage of copper production may be driving copper prices rather than the ‘Doctor Copper’ theory that the price of copper indicates the state of things on the demand side of the equation.
Rio Tinto’s three big weaknesses
The price of copper has been sinking for five years or so in line with other commodities but it also participated in the bounceback during early 2016. However, I’m not putting any faith in Doctor Copper’s diagnosis for the economy. I reckon copper, the other commodities, and the share prices of big mining firms such as Rio Tinto could be caught in the currents of a tsunami of speculation, perhaps driven more than ever in today’s world by the masses in China.
Rio Tinto’s three big weaknesses are that:
1) The firm has almost no pricing power for the product it produces
2) Demand is cyclical
3) Costs are volatile.
That’s a poor set of circumstances on which to base any business model and leads to wilder outcomes for investors when those factors are put on steroids with an overdose of speculation.