Being beholden to the whims of Chinese demand for construction inputs and vulnerable to changes in the production levels of competitors means Rio Tinto (LSE: RIO) will never escape its cyclical nature. However, with best-in-class assets and a healthy balance sheet, is Rio the best way for long-term investors to gain exposure to commodities?
The key to Rio's future is iron ore, which is both its greatest strength and greatest weakness. Unlike competitors who used the commodity supercycle as an excuse to load up on debt and branch out into borderline financially viable non-core commodities, Rio remained largely focused on iron ore.
This means two things. First, its portfolio is filled with world class iron ore mines with very low production costs. Take the past half year for example. Even as prices sank to lows not seen in nearly a decade, Rio's iron ore division still produced a full $1.7bn in underlying earnings.
The downside to this lack of diversification is that if prices remain as low as they are currently, Rio doesn't have much room to appreciably grow earnings. And the outlook on this front is poor. Demand is slowing as China, the world's largest consumer, slows its decades long infrastructure binge and global supply is still rising as new mines come online and cost cutting allows for cheaper production.
There's better news when it comes to Rio's relatively healthy balance sheet. The miner was focused on lowering leverage levels even before the end of the commodity supercycle and gearing is now down to a very manageable 23%, which together with low-cost-of-production assets means annual 110¢ dividends are very safe. There are much worse options than Rio in the commodity sector but with the outlook for iron ore dim, I won't be counting on shares for the long term.
Debt, debt, debt
A healthy balance sheet is but a distant dream for West African oil producer Tullow Oil (LSE: TLW), where net debt of $4.7bn represents a staggering 62% gearing ratio. Like other producers caught up in the heady times of $100/bbl oil pre-2014, Tullow borrowed enormous sums to fund production in vast offshore deposits.
The good news for Tullow shareholders is that the billions spent on developing the TEN field off the coast of Ghana are finally paying off. First oil began flowing from the field in August and with production ramping up and capex falling precipitously, Tullow can begin to make a dent in its mountain of debt.
Unlike other London-listed mid-cap producers that are largely focused on ageing fields in the North Sea, Tullow's assets in relatively balmy African seas are also incredibly low cost. Over the past six months Tullow's underlying operating costs in Ghana averaged $9/bbl and the company expects to be free cash flow positive with oil around $50/bbl.
Now, where oil prices will go in the near future remains as opaque as ever and Tullow's very, very high levels of debt worry me. But, if prices stabilise at current levels and the company can drastically improve its balance sheet then the low-cost-of-production assets may be mightily attractive to investors and potential acquirers alike.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has recommended Rio Tinto. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.