In Hunt for Coal, Rio Tinto Presses Deeper into Africa

Rio Tinto has prided itself on the fact that more than 80% of its assets are located in countries that are members of the Organization for Economic Cooperation and Development, a sign of more stable economies and governments. Thus its $3.9 billion deal last month to buy Australian-listed Riversdale Mining Ltd., whose principal assets are in Mozambique, represents a strategic shift for the global mining concern.

Riversdale will double Rio Tinto's African gross assets, catapulting that continent past the U.S. in importance for the Anglo-Australian miner. Following on the heels ofits multibillion-dollar investment in a metals project in Mongolia, the Riversdale acquisition signals Rio Tinto's need to take on political risks it has shunned.

In this case, there are precious few top-quality reserves of hard coking coal, or metallurgical coal. Riversdale expects that by 2025, Mozambique will supplant the U.S. as the world's second-largest exporter of metallurgical coal, used for steelmaking, after Australia. The Riversdale acquisition has the potential to more than double Rio Tinto's current managed production of the fuel to more than 30 million tons per year after 2020, according to a Rio Tinto spokesman.

Riversdale didn't have the financial wherewithal to bring the African reserves to production, however. As with the similarly sized Mongolian Oyu Tolgoi copper-gold mine, which had a development cost of around $5 billion and where Rio Tinto also became involved, Rio Tinto brings operating credibility, depth of experience and marketing resources as well as financial backing.

There are other similarities. Like Mongolia, Mozambique needs to raise its technical and educational levels to attain industrial competency on par with developed countries. The local work force needs to learn the science of mining coking coal to ensure the consistent quality and output available from Australian, Canadian or U.S. mines.

But developing the Mozambique mines will be no mean feat. There is significant credit risk that will add to Rio Tinto's financing costs. The country has a single-B-plus bond rating from Standard & Poor's, one notch below Mongolia's double-B-minus and well into non-investment grade.

Ravaged by civil war between 1977 and 1992, Mozambique depends on foreign aid for more than half of its annual budget, and the majority of the population lives below the poverty line. The majority of coking-coal exploration activity in the country has taken place since 2004, giving Mozambique a short record of dealing with foreign mineral development. That, as well as the social tensions stemming from poverty, contribute to political risk.

Although it's early for any assessment of project financing, lending rates for a 10-year loan could easily top four percentage points over the London interbank offered rate. This assumes using international development banks and export-credit agencies besides commercial banks to cover political risk, as well as a deal structure of 30% equity and 70% debt.

Rio Tinto has moved at an opportune moment. Not only did it strike while competitors were focused on problems of their own, but it inked the deal just before floods in Australia cut off much production there and sent coking coal prices soaring. They have hit $250 a ton and could reach $300 when the next quarterly contracts are priced, up from $170 in 2009 and $190 in 2010.