OUTLOOK FOR METALS AND MINERALS. Half Year Results August Rio Tinto Economics & Markets

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1 Highlights OUTLOOK FOR METALS AND MINERALS Half Year Results August 2013 Rio Tinto Economics & Markets In the past six months trends in commodity prices have been influenced by key macroeconomic themes: below expectations but stable Chinese growth; shifting sentiments regarding the future unwinding of Quantitative Easing in OECD countries; continued underlying structural issues in Europe; and exchange rate fluctuations. Iron ore prices have fluctuated between $110 $160 per dry metric tonne delivered to China during the first half of 2013, averaging about 13 per cent above the second half of The iron ore market has been supported by strong Chinese demand. Copper prices fell 15 per cent during the first half of the year, averaging close to $7,500/t ($3.40/lb), with the market moving into a slight supply surplus. Aluminium prices were below the marginal cost of production as they averaged $1,900/t in the first half of At this level, around 25 per cent of ex-china capacity is cash negative. Thermal coal fell to the lowest point since November 2009 towards the end of June, reaching a low of $79/t, below the first-half average of $89/t, with Australian producers currently facing substantial pressure on margins. Metallurgical coal markets weakened substantially to US$130/t due to strong supply growth from major seaborne producers and ongoing weakness in import demand. Despite these recent price declines, most commodities, with the exception of aluminium, remain at historically elevated levels. For example, iron ore and gold prices are double those of early Commodity daily spot prices Index (`1 Jan 2007 = 100) Prices at 5 th Aug $121/dmt $1,299/oz $109/bbl $77/t c/lb 50 0 Jan 07 Apr 07 $1,754/t Aluminium Copper Gold Oil (Brent) Iron ore (62% Fe FOB WA) Thermal coal (FOB Newc) Jul 07 Oct 07 Jan 08 Apr 08 Jul 08 Oct 08 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Source: Datastream, Platts Looking forward, we maintain our view on the Chinese economic transition towards a consumption-led growth model. Although the commodity-intensity of growth is expected to decline, the slower growth rate will still provide substantial absolute demand levels and new commodity sales opportunities will become available. China s transformation is likely to be volatile as a result of the uncertain timing and speed of the reform process. Oct 10 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 1 of 6

2 The mining industry, which previously struggled to keep pace with the acceleration in global demand, is also undergoing transition as it shifts from a decade-long growth phase to become focused on costs and cash flow. Reductions in capital expenditure, project deferrals and cancellations, improving productivity and removing cyclical costs have swiftly become core to mining industry strategy. Over the medium to longer term, the complexity of projects is expected to continue to increase, adding to project delays and increasing capital intensity. This is likely to keep prices for some commodities above historical levels. Macroeconomic overview Macroeconomic themes Volatility has been a characteristic of macroeconomic environment since the Global Financial Crisis (GFC) and will remain so. Systemic risks abound while a definitive path to the key challenges facing the economy is unresolved. China s economic growth has been below initial expectations so far this year but has remained stable and on par with the growth performance experienced last year. The latest consensus view points to growth in 2013 achieving the government s target of 7.5 per cent. The uncertainty surrounding the eventual unwinding of Quantitative Easing (QE) is influencing market expectations and asset valuations. Despite the US Federal Reserve linking asset purchases and short-term interest rates to economic conditions, specifically unemployment, US bond yields have started to increase and money has been flowing out of exchange-traded funds and precious metals. Further European contraction in 2013 highlights the persistence of underlying structural weaknesses and until these deficiencies are addressed financial shocks remain a distinct possibility. Central Bank actions to date have only postponed the inevitable readjustment that is required. The USD has appreciated at the expense of commodity-central exchange rates such as the AUD and CAD. GDP growth The consensus now points to lower global economic growth for 2013 and 2014 compared with expectations at the beginning of the year. Key regions appear to be at varying stages of the recovery cycle and are facing quite different challenges. China s GDP growth has been influenced by four major government policy interventions since February: 1) curtailment of excessive government spending; 2) tightening of property price controls; 3) efforts to reduce false export invoicing and speculative foreign exchange inflows; and 4) controls limiting risky off balance sheet credit products, which induced a liquidity squeeze. While we do not expect a banking crisis or hard landing, the changes in credit policy will continue to have a negative impact on investment for the remainder of the year, maintaining a stable near-term growth outlook. The Eurozone economy continued to deteriorate this year with the unemployment rate rising throughout the year. It now looks likely that the recession will continue into Q with the best case scenario being a return to positive territory in Q The Japanese and US economies have continued to rebound, with the Japanese economy returning to positive growth on the back of expansionary monetary and fiscal policies. In the US we have seen continued strong growth in the housing sector and stock market and a continuing downward trend in the unemployment rate. India is expected to witness a mild economic recovery in 2013 of five and a half to six per cent growth. The major downside risk is the large current account deficit, its financing and the resultant pressure on the India Rupee. Looking forward, the outcome of the central 2 of 6

3 elections due over the next 12 months will prove crucial towards defining the reform path and the return to a sustainable high economic growth trajectory. Currencies World Economic Activity and Consumer Price Inflation Real GDP Growth (%) Consumer Prices Growth (%) Australia Brazil Canada China Eurozone India Indonesia Japan Russia South Korea Taiwan UK US World Source: Global Insight (July 2013) Expectations that the US Federal Reserve will soon exit its bond buying programme combined with strong economic growth has seen funds flow back into the US economy over the course of 2013 and strengthened the value of the USD against most currencies. Exchange rate index 105 Index (31 Dec 2012 = 100) Canada China Euro Japan UK Australia 80 Dec 12 Jan 13 Feb 13 Mar 13 Apr 13 May 13 Jun 13 Jul 13 Source: Datastream The Australian dollar has also depreciated significantly in the last couple of months as a result of a combination of weak China growth data, the strengthening of the US dollar and a growing view of a more proactive Reserve Bank of Australia monetary policy. Whilst volatility remains very high, it does look like there has been a fundamental downward shift in the AUD s perceived market value, which will relieve margins of Australian mining producers. The Canadian Dollar has only depreciated moderately over the past couple of months as it is not as dependent on Chinese growth and has not seen a decline in domestic interest rates expectations. 3 of 6

4 Commodity markets Costs The mining industry is cyclical. The current phase of lower prices and margin compression is forcing increasing industry focus on costs and capital discipline. This is also translating to procurement, contractors and suppliers to the mining sector. The Heavy Mobile Equipment (HME) market has continued to soften with shipments declining 42 per cent compared to the peak in the first quarter of 2012, although still well above the trough in In the past six months, lead times for HME and capital equipment have stabilised. Although market prices have fallen they have not done so in proportion to the demand reduction. Off-the-road tyre prices have been declining in parallel with rubber prices and demand is showing signs of slowdowns. Lower levels of demand are likely to result in improved inventory optimisation as the inventory is balanced with the supply risk. In response to the new mining environment, Original Equipment Manufacturers are repositioning themselves to focus on cost efficient technology for equipment replacement orders rather than filling new large capital orders. Aluminium, alumina and bauxite Aluminium prices were below the marginal cost of production as they averaged $1,900/t in the first half of At this level, around 25 per cent of ex-china capacity is cash negative. The strong contango yield continues to incentivise stock financing with LME stocks rising six per cent to 5.5 Mt in The continuation of these financing deals is expected if interest rates remain low. Proposed changes to LME warehousing rules are aiming to reduce the length of queues and are likely to have a negative impact on premiums by reducing incentives to purchase metal for storage. Aluminium is expected to exhibit strong consumption growth relative to other commodities over the medium term. This is predominantly driven by the transportation, construction and consumer durables sectors. Despite this positive demand context we would expect the aluminium market to remain well supplied in the near-term as economic incentives drive the addition of further new smelting capacity in north-west China. China s strong production growth is putting pressure on its constrained bauxite resources, with local grades falling further. This is a positive factor for future bauxite prices. Approximately 80 per cent of China s bauxite imports are currently shipped from Indonesia. The Indonesian unprocessed ore export ban is set to come into full effect from January 2014, and, while there is continued uncertainty over how this will be implemented, this represents a key risk for bauxite and alumina prices. Copper Copper prices have continued to drift down, averaging close to $7,500/t ($3.40/lb) during the first half of the year. The copper market is in surplus and this has contributed to price declines. Despite recent production disruptions at Grasberg and Bingham Canyon the output from key producing countries has been increasing Chilean production is up 4.4 per cent year to May and Peruvian production up 5.5 per cent in the year to April. The International Copper Study Group reported that world apparent usage of copper declined by over five per cent year-on-year in the first quarter, but a portion of this apparent decline was due to the stock withdrawals in China. Higher production and weakening demand is resulting in rising global warehouse stock levels as LME inventories climbed to the highest level for ten years, around 680 kt. 4 of 6

5 The slight surplus in the copper market is likely to persist into the next 12 months, with new mine supply volume coming online and few signs of strong demand acceleration. Further out we expect significant supply challenges, with copper miners continuing to face declining grades, stakeholder pressures and project delays. Iron ore In the first half of 2013, the iron ore market has displayed the volatile nature that we have come to expect with prices ranging from $110 to $160/dmt CFR China. The current magnitude of change is in keeping with the past four years of iron ore prices. As the iron ore market evolves over the coming year we should expect volatility to continue. Following the iron ore destocking events of August to September 2012, we have seen a sustained rally in iron ore prices to a first half 2013 average of $137/dmt CFR China. The rebound in prices was driven by a return to stable inventory conditions and a run-up in demand in key regions such as China, where steel production has reached highs of 800Mtpa in early China has experienced strong year-to-date steel growth, led by the construction sector. Residential construction has been particularly strong, with activity in real estate spurred by credit expansion and rising house prices in virtually all large and medium-sized cities. Sales by developers have increased by 35 per cent so far this year and floor space completed grew strongly in Q but decelerated across April and May. Infrastructure growth has been generally robust across different sectors since mid Road and rail growth has exceeded 20 per cent year-to-date, driven by supportive Government policies reaching execution stages. The backdrop to these strong demand conditions has been volatile, yet growing, supply. A 17 per cent increase in Australian exports has contributed to this trend but Brazilian exports are down by 5.6 per cent and India continues to be largely removed from the seaborne market. The near outlook points to robust steel demand conditions counterbalanced by a growing seaborne supply. These conditions will continue to generate further price volatility due to the steepness of the iron ore supply curve. Thermal coal By the end of the first half of 2013, the thermal coal market had seen the price gains of the fourth quarter of 2012 eroded down to the lowest point since November 2009 with Newcastle prices down 18 per cent to $79/t. This weakness extends to Richards Bay and European prices. Despite recent AUD weakness, Australian producer margins are still under substantial pressure with an industry wide focus on cost compression in an attempt to avoid production cuts. Market discipline has been mixed as global supply has risen two per cent in the first half of 2013 compared to the previous year. Reductions in key markets, (China, US and Colombia) have been countered by stronger Australian, Indonesian and South African exports. While import demand from India and China has been strong, up 13 per cent and 26 per cent respectively, this has been insufficient to halt the price slide. China Independent Power Producer stocks are in excess of 20 days of supply and Indian stocks are at five-year highs. A Chinese low calorific value coal import ban could provide some minor upside, but it is looking increasingly unlikely to pass. Metallurgical coal In the first half of 2013, metallurgical coal markets weakened substantially with prices for prime hard coking coal falling from February highs of US$170/t to finish June at US$130/t. Contributing to the weak price environment was strong supply growth from major seaborne producers and ongoing weakness in ex-china import demand. These factors led to contract settlements for prime hard coking coal in Q3 to be settled at levels not seen since of 6

6 Leading the seaborne supply increase in the first half of 2013 were Australian producers, with exports of hard coking coal up around 10 per cent on a year earlier. Shipments increased as issues associated with the 2011 Queensland floods and industrial action at BMA s Queensland operations were largely resolved and efforts across the supply chain to lower unit costs through higher production took place. North American supply also remained strong as an increase in Canadian exports, helped by the re-commissioning of a birth at Westshore terminal, more than offset a modest decline in US exports. Metallurgical coal demand from traditional import markets remained weak with China remaining one of the few growth markets. Other commodities Uranium spot prices are at their lowest price since late 2005 as demand remains low and inventories increase. Despite the Japanese Nuclear Regulation Authority starting to review reactor restart applications, local government agreements are still needed and are likely to delay any price recovery. The market for titanium dioxide and zircon has softened further over the course of the year as the industry continues to deal with high levels of stocks. Rough Diamond prices rose in the first half of Demand for commercial quality goods remained steady but higher quality demand is sluggish. The near-term outlook points to a softening rough market with manufacturing margins under pressure from a weaker Indian Rupee and tighter bank lending. 6 of 6