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Here's Why This Miner Just Sold the World's Biggest Iron Ore Deposit

When you're sitting atop one of the world's biggest mineral deposits, selling it isn't the first thing you think of doing, but Rio Tinto's (NYSE: RIO) decision to sell its stake in the massive Simandou iron ore project in the west African republic of Guinea isn't necessarily a surprise or unwarranted.

Although China's response to steel industry overcapacity has caused iron ore prices to rally, the vast resources at Simandou remain uneconomic to extract. Image source: Getty Images.

Altering the landscape

Simandou is big, and it's one of the richest concessions in the world of mining, containing an estimated 26 billion tonnes of high-grade iron ore worth more than $50 billion. At full production, Rio Tinto said it would produce 100 million tonnes annually and would add $7 billion in revenues each year at a price of $75 per metric ton.

While that price might have seemed a stretch after iron ore fell to a near decade low of $37 a tonne last December, the mineral has rallied throughout 2016 and hit $80 per tonne this past Friday.

Industry executives like BHP Billiton's (NYSE: BHP) Andrew McKenzie warned earlier this year, when the price was much lower, that the rally was unsustainable because structural imbalances in supply and demand virtually mandate a new correction. He told a group of analysts this summer: "We've had such a long boom. To walk that through, in my view, may take another 10 years."

China's thumb on the scale

But China is the proximate cause for a rally that's defied expectations. It sought to reduce capacity in the steel industry this year by 45 million tonnes, with plans of eliminating 100 million to 150 million tonnes of annual steel production over the next five years. Coupled with production cuts by the mining industry's leaders, and it was a prescription for the rally that's under way in iron ore, a key ingredient in steelmaking.

On the one hand you have China's Baosteel Group announcing it will cut steel production capacity by 11 million tonnes over 2016 and 2017, well above the 9.2 million tonnes of excess capacity it said in July it would cut by 2018, while on the other earlier in the year you had BHP Billiton, Rio Tinto, and Vale (NYSE: VALE) all announcing they were initiating substantial cuts in ore production.

And now new rounds of cuts may be coming again as Rio Tinto said late last month it would further cut its guidance for 2016 iron ore shipments by an additional 5 million metric tons. It now forecasts shipping 325 million to 330 million metric tons this year, down from its earlier guidance of 330 million tons (BHP has so far held steady in its forecast).

At the same time, demand has risen in China as it seeks to meet GDP growth projections. Infrastructure projects and property development are seen as two markets that are being pushed to meet estimates of 6.7% economic growth this year. The combination of rising demand and falling supply have caused iron prices to double in 2016.

Image source: Getty Images.

Beijing has set off a similar rally in coal that has started to run away from its efforts to contain it. While originally designed as a stealth bailout of the industry suffering from depressed prices, a move that's led power generation companies to stockpile coal ahead of winter, China is now trying to put the toothpaste back in the tube by giving certain advanced miners permission to boost output again.

Too little, too late

Yet the iron ore rally wouldn't necessarily help Rio Tinto with Simandou, as the project still requires at least $20 billion in investments before it can become operational. Because of its remote location, some 80 miles of roadway would first need to be built along with 400 miles of railroad track, because the Guinea government insists domestic ports be used to ship any ore mined and won't permit Simandou's operators to use nearby ports in Liberia.

Although Rio Tinto had sunk some $3 billion into Simandou, it subsequently wrote off virtually the entire value of the project earlier this year leaving just $10 million in carrying value on the books. Rio is trying to reduce its heavy debt load and it just won't have the funds necessary to finance all the infrastructure needed to bring the project to fruition. Back in May, for example, the miner slashed its dividend in half as it sought to further cut its operating costs.

Others in the industry are doing the same, with Vale looking to reduce its own debt load by $10 billion through asset sales and cost-cutting. It recently told the Financial Times that if iron ore prices remain elevated, it may be able to squeak by without having to sell anything.

Simandou's remote location makes accessing its vast resources an expensive undertaking. Image source: Rio Tinto.

Alleviating a headache

By selling it to its partner Chinalco, it rids Rio Tinto of the cost of maintaining it while eventually recouping some of its investment in it. As part of the sales agreement, Rio will receive between $1.1 billion and $1.3 billion when commercial production begins, based upon the mine's output. 

Chinalco, as a state-owned enterprise, doesn't necessarily have the same restrictions that impede privately owned companies. Dumping billions of dollars into building roadways and railways if it allows it to corner the market on iron ore may be considered a national imperative that lets it forge ahead regardless.

Because Rio Tinto is constrained by its fiduciary responsibilities, it was ultimately a smart decision to sell Simandou despite the lucrative reserves it contained.

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Rich Duprey has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale. 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.