Financial review
Commodity prices
The Group's normal policy is to sell its products at prevailing market prices. Exceptions to this rule are subject to strict limits laid down by the Rio Tinto board and to rigid internal controls. Rio Tinto's exposure to commodity prices is diversified by virtue of its broad commodity spread and the Group does not generally believe commodity price hedging would provide long term benefit to shareholders. The Group may hedge certain commitments with some of its customers or suppliers. Details of commodity derivatives held at 31 December 2008 are set out in note 34 to the 2008 Full financial statements. The forward contracts to sell copper were entered into as a condition of the refinancing of Palabora in 2005. Many of the aluminium forward contracts and embedded derivatives were acquired with Alcan.
Metals such as copper and aluminium are generally sold under contract, often long term, at prices determined by reference to prevailing market prices on terminal markets, such as the London Metal Exchange and COMEX in New York, usually at the time of delivery. Prices fluctuate widely in response to changing levels of supply and demand but, in the long run, prices are related to the marginal cost of supply. Gold is also priced in an active market in which prices respond to daily changes in quantities offered and sought. Newly mined gold is only one source of supply; investment and disinvestment can be important elements of supply and demand. Contract prices for many other natural resource products including iron ore and coal are generally agreed annually or for longer periods with customers, although volume commitments vary by-product.
Certain products, predominantly copper concentrate, are 'provisionally priced', ie the selling price is subject to final adjustment at the end of a period normally ranging from 30 to 180 days after delivery to the customer, based on the market price at the relevant quotation point stipulated in the contract. Revenue on provisionally priced sales is recognised based on estimates of fair value of the consideration receivable based on forward market prices. At each reporting date provisionally priced metal is marked to market based on the forward selling price for the period stipulated in the contract. For this purpose, the selling price can be measured reliably for those products, such as copper, for which there exists an active and freely traded commodity market such as the London Metal Exchange and the value of product sold by the Group is directly linked to the form in which it is traded on that market. At the end of 2008 the Group had 183 million pounds of copper sales (2007: 270 million pounds) that were provisionally priced at 133 US cents per pound (2007: 304 US cents per pound). The final price of these sales will be determined in 2009. The impact on earnings of a ten per cent change in the price of copper for the provisionally priced sales would be US$15 million (2007: US$58 million).
Approximately 24 per cent of Rio Tinto's 2008 net earnings from operating businesses came from products whose prices were terminal market related and the remainder came from products priced by direct negotiation. The reduction from 52 per cent in 2007 is due to the reduction in Copper net earnings combined with a significant increase in Iron Ore and Energy net earnings.
The Group continued to achieve high average prices for its products in 2008 despite prices in terminal markets declining sharply during the second half of the year.
The poor economic outlook and weakness in metals demand is likely to weigh on average prices in 2009. In the longer run, urbanisation and income drivers in emerging markets in countries such as China and India are likely to reassert themselves in rising demand for metals.
The approximate effect on the Group's underlying and net earnings of a ten per cent change from the full year average market price in 2008 for the following products would be:
| Unit |
Average market price for 2008 US$m |
Effect on underlying and net earnings of 10% change in full year average +/- US$m |
|
|---|---|---|---|
| Copper | pound | 3.20 | 389 |
| Aluminium (a) | pound | 1.18 | 739 |
| Gold | ounce | 872 | 30 |
| Molybdenum | pound | 31 | 62 |
| Iron Ore | dmtu | n/a | 829 |
(a) The above sensitivities are based on 2008 volumes.
(b) Excludes impact of commodity derivatives.
The sensitivities give the estimated impact on net earnings of changes in prices assuming that all other variables remain constant. These should be used with care. As noted previously, the relationship between currencies and commodity prices is a complex one and changes in exchange rates can influence commodity prices and vice versa.
The table below summarises the impact of changes in the market price on the following commodity derivatives including those aluminium forward and option contracts embedded in electricity purchase contracts outstanding at 31 December 2008. The impact is expressed in terms of the resulting change in the Group's net earnings for the year or, where applicable, the change in equity. The sensitivities are based on the assumption that the market price increases by ten per cent with all other variables held constant. The Group's 'own use contracts' are excluded from the sensitivity analysis below as they are outside the scope of IAS 39. Own use contracts are contracts to buy or sell non financial items that can be net settled but were entered into and continue to be held for the purpose of the receipt or delivery of the non financial item in accordance with the business unit's expected purchase, sale or usage requirements.
These sensitivities should be used with care. The relationship between currencies and commodity prices is a complex one and changes in exchange rates can influence commodity prices and vice versa.
Products |
Effect on net earnings of 10% increase from year end price US$m |
Effect of items impacting directly on Rio Tinto share of equity of 10% increase from year end price US$m |
|---|---|---|
| Copper | - | (13) |
| Coal | - | (8) |
| Aluminium | (62) | (16) |
| Total | (62) | (37) |
