What I Learned From Rio Tinto

 | Jan 17, 2013 | 4:30 PM EST  | Comments
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News of Rio Tinto's (RIO) unexpected $14 billion write-down tells two stories, and both are important to traders of commodity stocks.

Let's start with the bad -- no, awful -- decisions by outgoing CEO Tom Albanese for the Anglo-Australian mining giant, specifically, the horrible overpayment for Alcan in 2007 -- a $38 billion acquisition left unrewarded by declining aluminum prices and an awful return on capital. I can see getting stuck in a very bad aluminum trade. I have often wondered over the past five years about prices of tin and aluminum -- the one metal that refused to give a spike in prices to trade off of. I asked myself if it could continue to fall, and I once got stuck in a buy of Alcoa (AA) in the hopes that I had found a bottom, only to see that, yes, aluminum could in fact go lower still. In thinking that aluminum would have its day, Albanese wasn't alone -- one could almost forgive him for that.

But the Mozambique screw-up is unfathomable: How can you spend $4 billion for a company, Riverside Mining, with assets for coal deep in the interior of a third-world nation run by thugs without first securing the rights to transport the mined coal you're hoping to produce? This is what apparently happened to Rio in Mozambique, as it has been unable to secure government approval to send barges up and down the Zambezi River from the coal mines to the coast. No barges? C'mon, what's the problem? Too much barge traffic on the Zambezi? Nah. Someone didn't do their homework on who to pay and how much. Right now, Riverside is a dead asset, and so is Albanese.

There are two things we can learn from Rio Tinto.

First, in commodity stocks, it's always about volume growth. Whether it's oil, coal or copper, we need growth and that leads us to very unsavory places with very interesting sovereign obstacles to overcome. Knowing where your investments are finding this volume growth is critical for choosing the right company in a sector, whether it's oil, coal or copper. This is why, for example, Noble Energy (NBL) is outpacing Anadarko (APC), and why EOG Resources (EOG) is a better performer than Southwestern Energy (SWN), and why VALE (VALE) can be so bad for so long. Understanding the chase for volume growth is the key to finding the right company in a sector. Know where they're investing so you know where to invest.

Second, commodity prices will trump even volume growth, and where commodity companies are looking to build it. Rio Tinto had a tremendous run before this disastrous write-down, moving above $60 a share on the back of an equally tremendous run in iron ore prices in the final quarter of 2012. Even with the incredible embarrassment at Rio Tinto, shares are still trading just north of $54. With the Chinese comeback and other Asian stimulus plans being put in place, you want a miner like Rio Tinto, still second to BHP Billiton (BHP), but much cheaper. The market tells me that if I can get shares just a little closer to $50, even with the firing of the CEO, I'm going to want to own it. You should too.

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