力拓 (RIO) 2021 Q2 法說會逐字稿

Good evening, and good morning, everybody. Welcome to Rio Tinto's First Half 2021 Results Presentation. Today, you'll hear from our CEO, Jakob Stausholm; followed by our CFO, Peter Cunningham. We have then reserved significant time for a Q&A session. (Operator Instructions) We have reserved 1 hour and 50 minutes for the session this morning.

Before I hand over to Jakob, please take a couple of seconds to look at the cautionary statement on Slide 2. Having done that, thank you very much, and Jakob, over to you.

Thank you, Menno. Ladies and gentlemen, good morning and good evening. When I presented our results in February, I set out a pathway to make Rio Tinto stronger, building what are clearly fundamentally robust foundations. To me, our performance this half reaffirmed the underlying qualities of Rio Tinto. It also highlighted the need to strengthen the business for the long term. We, again, achieved a strong safety performance despite challenging conditions. It remains our first priority, and we will never be complacent.

Government stimulus to aid economic recovery in response to ongoing COVID pressures led to robust demand for our products at a time of ongoing supply constraints. As a result, we saw a significant and prolonged price spikes during the first half, leading to strong free cash flow.

As an industry, we benefited from host governments recognizing mining as an essential business. It allowed us to focus on safely operating our world-class assets and delivering products to our customers despite necessary COVID restrictions. This meant people remain employed, suppliers had our business, and taxes and royalties continue to be paid. And our people once again demonstrated their agility, resilience and commitment to Rio. This is particularly true in terms of dealing with COVID.

In 2020, we scrambled to keep our operations running. In 2021, COVID has been even more challenging, especially in terms of our ability to get people to our assets. This is particularly true in Mongolia and in Western Australia. However, our fundamentally strong foundations enable us to achieve EBITDA of $21 billion and return on capital employed of 50%. We recorded $7.3 billion of taxes, have invested $3.3 billion in growth and sustaining CapEx, leading to a free cash flow in excess of $10 billion. As a result, we will return $9.1 billion to our shareholders. This is in line with our dividend practices and reflects a strong pricing environment. However, we remain cautious on the outlook and must ensure we remain resilient in all scenarios.

In June, I was very pleased to be able to travel to our Jadar project in Serbia, meeting with some key stakeholders and visit the team on the ground. This week, I'm proud that we have committed funding for Jadar. This is an important forward, moving Rio Tinto into battery materials at scale. It also demonstrates our commitment to investing capital in a disciplined manner to shape our portfolio for the future.

Lithium is a key commodity for the electrification of transport, large-scale batteries and energy storage. We have a critical role in supplying the metals and minerals required for the global energy transition.

Despite our outstanding financial performance the past 6 months, has confirmed that there clearly are areas where we need to improve. Firstly, to be the best operator. In the first half, we experienced too much operational instability. We are addressing this in a systemic manner and will sharpen the consistency of our performance.

Secondly, the 100-plus stakeholder meetings I have had in the first half have just strengthened my conviction that the foundation for our business is to achieve applicable ESG credentials. In order to sustainably deliver shareholder returns, we must ensure all our stakeholders benefit from the success of Rio Tinto.

Thirdly, we must excel in development, both organically and inorganically. We will only pursue opportunities that create value. Jadar is a perfect example.

And then finally, we must become a more outward-looking company more in tune with society. This is our social license to operate. It's judged by others and essential for long-term success. We are making tangible and lasting changes to the way we engage, interact and operate. This goes beyond my leadership team and is being embedded across the entire company to ensure we are making sustainable changes.

Let me now hand over to Peter to take you through the financials.

Thank you, Jakob, and good morning, and good afternoon, everyone. Let's first turn to the markets.

All our commodities benefited from strong demand globally. Growth in China slowed but remained robust. In the rest of the world, stimulus and the gradual easing of COVID-19 restrictions boosted consumption of our products. The iron ore price continues to confound most market commentators' predictions. This was driven by a surge in global demand, while supplies struggled to keep pace.

China's first half steel demand was up 9% year-on-year, with the construction and automotive sectors both performing well. Consumption was also robust across the rest of the world, where demand recovered by 15% compared with the first half of last year. Meanwhile, iron ore supply from the majors continued to lag expectations with high-cost production balancing the market.

Scrap is now recovering from the lows in 2020, with global first half consumption set to rise 18% as crude steel output and scrap availability improve. These factors led to the iron ore price more than doubling in the first half of 2021. However, with tightening credit conditions and a softer housing market in China, coupled with expectations for rising seaborne supply, it seems unlikely that such elevated pricing will persist.

Turning to our other commodities. Aluminum has been supported by tight physical markets with elevated LME and premium and strong demand in global semis, up 8% versus last year. Supply disruptions in China and limited restarts elsewhere have translated into price gains of around 41%. Copper prices have rallied 66%, driven by multiyear weakness in supply growth, with mine supply up just 1% and a strong recovery in global demand. We also saw strong end-use demand for TiO2 across all regions with pigment prices and utilization rates increasing throughout the first half.

Now on to our financial results. We've announced a very strong set of financials against the backdrop of an unprecedented recovery in global demand. It was also a very clean set of results with few exceptional items and no impairments. Starting with revenue. The 71% increase was mostly driven by price, in particular iron ore. The resultant increase in profitability lifted our return on capital to 50% and underlying earnings to $12.2 billion, just below the level we recorded for the 2020 full year.

Free cash flow amounted to $10.2 billion. And this was after a $1.2 billion outflow related to working capital, mostly as a result of higher price levels flowing through receivables and $3.3 billion on capital expenditure, up 24% year-on-year. The Board was therefore able to declare total dividends per share of USD 5.61, which I'll come on to a bit later.

Let's now take a closer look at the underlying drivers of profitability and cash flow. As ever, the biggest driver has been commodity prices. These boosted EBITDA by $12.8 billion in aggregate. The bulk of this was iron ore, but aluminum and copper were also important contributors. The appreciation of the Australian dollar and Canadian dollars relative to the U.S. dollar reduced profits by $600 million. Lower volumes and product mix resulted in a $400 million reduction, mainly due to lower iron ore shipments from the Pilbara. This, in turn, drove up unit cash costs through fixed cost inefficiencies.

We also experienced higher demurrage costs due to adverse weather in the Pilbara and Queensland, and an increase in maintenance expenditure. It was not a great half for our physical performance, but we delivered strong financials. We maintained our tight controls despite this period of high prices, with continued focus on costs and disciplined allocation of capital, including working capital. As Jakob stated earlier, we're not where we would like to be operationally. Nevertheless, due to our continued discipline and cost containment, we managed to retain over 90% of the benefit from higher prices and delivered EBITDA of $21 billion.

Let's look at each division, starting with iron ore. We experienced operational challenges in the first half, namely a mix of prolonged wet weather, shutdowns to enable replacement mines to be tied in and the protection of heritage sites. Their combined effect, together with COVID-19 restrictions and labor shortages was to lower production by 5%. This, in turn, led to a 3% reduction in shipments.

We have maintained guidance for 2021, but it is now at the low end of the range. I should also stress that it is dependent on tie-in and ramp-up of the replacement mines and ongoing cultural heritage management. Our unit cash costs were also impacted, rising to $17.90 a tonne in the first half. Much of this was due to the 17% strengthening of the Australian dollar. However, about $1 per tonne can be attributed to weaker volumes and an increase in costs, including demurrage and labor. As a result, we have updated our guidance to between $18 and $18.50 a tonne for 2021.

Clearly, with the significant improvement in prices, we achieved very strong financials with underlying EBITDA of $16 billion and free cash flow of $9 billion, both more than double 2020 1st half.

As we said at the Capital Markets Day in 2019, we recognized 2020 and 2021 would be challenging years where we had to run mines hard. However, we will come out of it as a much stronger business. This year, we tie in approximately 90 million tonnes of capacity of replacement mine capacity at our existing hubs in Robe Valley, West Angeles and Tom Price through the Western Turner Syncline development. Furthermore, we commissioned Gudai-Darri, a 43 million tonne mining hub, our first new hub since Nammuldi came on stream in 2014.

The tight labor market in Western Australia is adding complexity. Nevertheless, all projects are progressing and are still expected to achieve first ore in 2021, although completion will be slightly later than planned. When Gudai-Darri achieves full capacity in 2023, we believe we will have the mine capacity in place to push the system and establish its sustainable capacity. Our work will focus on synchronizing mines, plant, rail and port. All these components need to operate efficiently and simultaneously to maximize system output. We will push productivity to offset a continued rise in the work index. And of course, we continue to face uncertainties around heritage and the construction of future replacement mines.

Like safety, heritage is a priority. We continue to engage with traditional owners regarding current and proposed mine plans and work through development scenarios together. The full impact of the reformed Aboriginal Heritage Act in Western Australia is still unknown.

Finally, we will always take into account the volumes and product quality that our iron ore customers demand. System capacity will increase with Gudai-Darri, but its full potential will only be determined with experience and the delivery of the improvements we are planning.

Moving on to aluminum. We saw the best financial performance from our aluminum division for over a decade. We delivered a significant uplift in EBITDA to $1.9 billion, more than double the first half of 2020 and a substantial increase in operating cash flow to $1.4 billion. Free cash flow of $0.9 billion already matches 2020 full year cash flow. Notably, all the Pacific smelters were cash flow positive in the period. Earnings were driven by a rebound in prices and higher aluminum sales, including heightened demand for value-added products. This was underpinned by the stability of our smelting business.

To support the higher value-added volumes, we have now rebuilt the working capital that we released in the first half of 2020. The positive drivers were only partly offset by the impact of stronger local currencies, some normal cyclical raw material price increases for coke and alloys and weaker bauxite shipments.

Overall, the underlying EBITDA margin for aluminum increased to 36%. Return on capital improved to 12% and the exit rate in June was significantly higher, demonstrating that this is the best global integrated aluminum business. Long term, we continue to work on finding solutions to reduce the carbon footprint of our business and make our Pacific smelting assets more competitive.

The partnership with ARENA to study whether hydrogen can replace natural gas in our Queensland alumina refineries is an important step to reduce emissions in such a hard-to-abate process.

At $2 billion, underlying EBITDA from our copper business was almost 3x more than the first half of 2020. The strong market environment was the key driver boosting underlying EBITDA by $1.3 billion, with a 66% increase in our realized copper price to USD 4.15 per pound. We also benefited from higher sales volume of refined product, driven by a solid smelter performance at Kennecott following the extended maintenance shut of last year and higher gold grades at Oyu Tolgoi.

While refined copper output was up at Kennecott, mined tonnes were lower following an anticipated slope failure. It will slow us down a bit and push some of those anticipated higher-grade tonnes from the south wall into 2022. We saw lower volumes at Escondida, where ongoing preventative measures in response to the resurgence of COVID-19 continued to impact workforce availability. Our C1 unit costs at $0.71 per pound were 43% lower, with the effect of reduced volumes from Escondida more than offset by higher gold credits at Oyu Tolgoi.

Free cash flow was positive at $0.6 billion, even after paying $0.4 billion to the Mongolian Tax Authority in relation to disputed tax items in the period 2013 to 2018, and higher inventory as COVID-19 restricted the transfer of product across the border to China.

Across minerals, demand conditions were strong. Operationally, we navigated challenges posed by COVID-19 at several assets. At IOC, reduced availability of labor and equipment reliability issues impacted production, but an 86% increase in pellet prices boosted the financial results. Our operations in Madagascar are performing well. At Boron, we completed a major planned maintenance program in May that should support strong second half performance. And at Diavik, production was slightly up and a sharp recovery in prices drove a return to profit.

At Richards Bay, we ceased mining operations on the 30th of June to protect the safety of our people after a period of heightened security issues. On the 21st of July, we fully shut down 1 of our 4 furnaces because of depleting feedstock. We continue to work with governments and communities to find a lasting solution to the current situation. However, if the situation does not improve, we could be forced to progressively shut down the other furnaces by the end of August.

Our underlying -- our overall underlying EBITDA of $1.4 billion was almost double 2020 1st half, primarily reflecting a $0.9 billion benefit from higher pricing across the portfolio, especially for our Canadian iron ore pellets and concentrates.

Now as both Jakob and I have said before, there is one thing that will not change at Rio Tinto, and that is our approach to capital discipline. You would have seen this slide many times before, but it is important to point out, we remain fully committed to it. We're determined to maintain that discipline during periods of elevated commodity prices. We are convinced that growth has to be about value generation and building sustainable cash flow. Investing to sustain our assets will always be core to what we do.

Beyond that, we will rigorously review all replacement and development projects, while we continue to shape our portfolio to keep on delivering the world -- the commodities the world demands for the decades to come. We still expect to invest around $7.5 billion in each of the next 3 years. Our guidance always included the Jadar lithium-borates project, which we are now committing funding for. Jakob will cover this off in more detail later.

COVID-19 remains a key risk for all our projects, driven by the challenges associated with interstate and international border access. This is having an impact on the availability and movement of people, particularly in Australia, Canada and Mongolia.

Net debt has turned into net cash of $3.1 billion at the end of June. But let's not forget that this is just one point in time. Today, we've made a $9.1 billion dividend commitment, which we will pay out in September, moving us back into net debt territory. There's still a lot of uncertainty in the world. Our balance sheet ensures we are able to continue to invest in the business to provide superior returns to our shareholders and create optionality.

Finally, on to shareholder returns. Our policy, well known to most of you, dates back to 2016. We commit to returning 40% to 60% of underlying earnings on average through the cycle with additional returns to shareholders in periods of strong earnings and cash generation. As you can see from this chart, over the last 5 years, we've consistently exceeded our policy, with an average payout ratio of 73%.

The first half of 2021 is no exception. We have always said the key decision point is around the final dividend. However, given the strength of our balance sheet and the extremely buoyant markets, we have announced today an interim ordinary dividend of $6.1 billion and a $3 billion special dividend. This brings the payout ratio for this year to 75%.

On that note, let me pass back to Jakob.

Thank you, Peter. During the past 12 months, governments around the world have become increasingly aligned in their focus on the transition to a lower carbon world. This transition will require more of everything we produce and underpins the demand for our commodities for the decades to come.

The images on this slide demonstrates exactly why many people see solar cells, wind turbines, transmission lines and electrical vehicles. I see a huge need not just for copper, aluminum and battery materials, but also iron ore. This is additional or new demand supplementary to long-established expectations of ongoing population growth and urbanization, the main drivers of historical commodity consumption.

What is also becoming clear in my mind is that societal expectations of how these materials are extracted will continue to evolve, driving scrutiny around transparency, CO2 footprint and how companies treat customers, communities, suppliers and employees. It reinforces why we have decided to focus on the 4 key areas I highlighted earlier. Our operational performance clearly isn't where it has been in the past or where we want it to be, ensuring we once again become the best operator is about restoring Rio Tinto's DNA.

Similarly, we have a proud track record of delivering projects on time and on budget and deploying our balance sheet to create long-term value and shared prosperity. Today's strong financial performance reflects the courage of leaders decades ago to invest in the iron ore business, which was not as profitable then as it is now. Finally and importantly, we need to ensure that we are seen as a crucial and integral part of society.

To truly unleash our full potential, we need to be more outward-looking. This is firstly about earning and protecting our social license. Clearly, this must happen wherever we operate. However, given the significance of Australia to Rio Tinto, I spent 3.5 months there earlier this year, I engaged extensively across Australia from our traditional owners in the Pilbara in the Northern Territory, to key government representatives, business leaders and our shareholders. I also met many current and former Rio employees. It was an opportunity to listen, to learn and understand how we need to adapt.

While some meetings were confronting, a key thing for me is that I did not meet a single person who did not want to see Rio Tinto succeed. I've also met stakeholders in China, New Zealand, South Africa, Serbia, Canada and Brussels. We have taken the insights from these meetings and are applying them to how we behave and operate globally. This isn't just about building capacity and strengthening governance, which are clearly important, but it's also how we engage in a respectful and collaborative manner. It's going to take time and great effort to rebuild trust, but I'm absolutely committed to doing this.

One of the attributes that attracted me to Rio Tinto was the company's long-standing commitment to how it operated beyond the financial performance. I'm often challenged internally and externally about exactly what I mean by impeccable ESG credentials. What I do know is that safety has always been core to how we operate. I know that every Rio Tinto employee recognizes good, bad and impeccable safety performance and nothing short of impeccable is acceptable.

I want to bring the same focus we have on safety to all areas of ESG. We will focus on real engagement with our communities, understanding their experience and never forgetting that in so many places, we're guests on their land. By being more transparent and modernizing multiple agreements, I recognize there will be some tension and testing times ahead, but it is vital that we get this right.

When I sat down to choose my leadership team, getting people with the right values was crucial to ensure we build a stronger and more engaged organization, but it needs to go deeper into the business. We are therefore implementing leadership and cultural awareness coaching to an extended team.

The key to achieving consistent operational excellence is our people. We will start by unlocking real and sustainable improvements at each asset. This is a great opportunity, which we are pursuing with rigor. Focusing solely on top-down processes and system solutions will not deliver sustained value. We will lead in a more supportive inclusive and people-focused way. Each of our product groups have contributed to the early framework design and identified pilot sites where the Rio Tinto safe production system will initially be rolled out.

Now turning to our portfolio. We need to remain relevant and be well placed to meet the commodity needs of future generations. We will build the capabilities in project development, evaluation and execution. Our portfolio should not be seen through a quarterly lens, but in terms of decades. Our history has demonstrated an ability to renew the portfolio and we will continue to do so within our capital allocation framework. In addition, we continue to further strengthen our project pipeline through our sector-leading exploration activity.

Turning to Oyu Tolgoi. Despite considerable COVID-related challenges, the team has done a great job. We have made considerable progress in all project-related technical criteria to support undercut commencement have been achieved. We are working on other elements such as government permitting that will enable us to proceed. We continue to engage with the government and have remobilized our negotiation teams following the recent presidential elections. There remains a clear shared goal as expressed by the government to move Oyu Tolgoi forward. I'm confident that we will be able to find a mutually acceptable solution to allow this impressive development to deliver for all stakeholders, including the people of Mongolia.

The Jadar project marks an exciting entry for Rio Tinto into battery minerals at scale. The market fundamentals for lithium are strong, with 25% to 35% demand growth per annum projected over the next 10 years, driven by the global energy transition. As one of the world's largest new greenfield lithium projects on the doorstep of the European Union, Jadar will be well placed to meet this demand. Jadar will produce battery-grade lithium carbonate, a critical mineral used in large-scale batteries for electrical vehicles and storing renewable energy. It could power over 1 million electric vehicles a year.

It will also -- it will be a direct and indirect catalyst for the Serbian economy, creating over 2,000 construction jobs and 1,000 ongoing jobs when operational. We are working hard to establish trusting and respectful relationships with local communities, including landowners, the Serbian government and other stakeholders. Subject to receiving all relevant approvals, licenses and ongoing engagement with local communities, construction will commence in 2022 with first production in 2026. We are excited about lithium and developing the Jadar project.

So let me summarize. Our safety performance remains strong, but we are not complacent. Our people and world-class assets delivered outstanding financial results driven by very supportive commodity markets. Our balance sheet enables us to invest in a disciplined way where we see attractive opportunities like Jadar. There's definitely room for improvement to build on these foundations. We have identified and are addressing what needs to be done, and I look forward to providing you further insights at our Capital Markets Day later in the year.

In the meantime, we are all focused each day on making Rio Tinto even stronger. We are now happy to take questions. Operator, can we please have the first call on the line?

(Operator Instructions) And the first question comes from the line of Paul Young from Goldman Sachs.

Jakob, a question on the Pilbara. The mines are clearly underperforming and sales in 2021 will be lower than 5 years ago. If I look out in 2 to 3 years' time, what will the total mine capacity be post the ramp-up of Gudai-Darri? And do you actually know what this number is?

So Paul, as you know, we are only giving production guidance for within the year. And you make some comparisons and some competitors are performing very strongly, but we were in the first half the world's largest producer of iron ore. I just want to remind you of that. And we have had a lot of project activities in the Pilbara here in the first half and we'll have that in the second half in order to finalize all the projects, including the new hub of Gudai-Darri.

When all that has been completed by the end of the year and we start ramping up next year, we have much more optionality in terms of product quality, in terms of cost, in terms of volume. But I'm not going to give you any guidance on future production. Thank you.

And the next question comes from the line of Jason Fairclough from Bank of America.

Just a quick question for you on Jadar, so your new project. You've announced the approval of the project, you've committed $2.4 billion in capital, but you don't seem to have the environmental approvals you need nor do you have the exploitation license. Is this back to front? I'm just wondering what's going on here.

No, look, I think it's all progressing extremely well, and I think we are very close to having an exploitation license. But we're trying to do this in a very transparent way. And we want to engage with everyone and moving this forward. I spent some good time in Serbia, and I feel very, very comfortable about having a project that are actually in the benefits of both communities and Serbia as a whole.

So I felt the project from a technical standpoint was ready to take to the Board. The Board likes it and approve the funding of it, and that's what we are announcing. And I'm looking forward to the next chapters.

Okay. So just in terms of time line to get these other approvals, how should we think about that? Sorry, just to follow up.

Well, what I'm saying is we expect to commence construction in 2022. So that means that it's pretty imminent on a number of things, but we do need to go through all the necessary consultation, and we'll do so. But I think we are in advanced stages of most of the work.

And the next question comes from the line of Rahul Anand from Morgan Stanley.

Look, another one on iron ore. From a production standpoint, one of the reasons alongside the tie-in activity and the ramp-up was management of cultural heritage. Could you please shed some light on this? In February when the reserves were written down, my understanding was that the near-term risk to the mine plan had been taken care of. Has the situation somewhat changed on the ground?

I understand there's still medium-term risk in terms of what happens with changing regulation. But in terms of the near term, as this was one of the cited reasons, is there any update there?

Peter, do you want to comment?

Very happy to. Thanks, Jakob. So we absolutely have reviewed all the sort of heritage sites in Pilbara. About 1,900 sites have been reviewed, and those did result in those write-downs to reserves that we talked about at year-end. I think what we're doing over and above that is learning how to manage with real care cultural heritage on an ongoing basis. And then in the first half of the year, we did sort of have probably a couple of million tonnes that we lost. Because when we're going through now our mine plans, all the time, we're reassessing thinking about cultural heritage.

And one example is on our blast management plants. About 11% of our blast now, we have specific plans, so we're managing with care around heritage sites. So I think we've really learned an awful lot in the business. But this is going to be something ongoing that we will have to manage in that respect. And so I think that we've built in for the longer term, that 54. But on an ongoing basis, we did lose that 2 million tonnes in the first half. Thank you.

And the next question comes from the line of Liam Fitzpatrick from Deutsche Bank.

Just a question on Simandou. There isn't a lot of incremental information in the release today. So when could you have to make a big decision or commit a capital on this project? Should we be thinking later this year or more into next year? And what are your latest thoughts on the ESG risks surrounding this project?

Yes. Thank you, Liam. We have worked on Simandou for many, many years, and we have knowledge about the ESG risk second to none, I would argue. But you're right, there's not a lot of news today because what is key is to get all stakeholders aligned. Of course, the government of Guinea, together with a number of primarily Chinese stakeholders and ourselves, and we are pursuing those discussions. I cannot set your time line because I can't control other time lines, of course. But we want to pursue this. We would love to participate. We have a lot to add to this project, but we need to find common ground on how to progress it.

In the meantime, we have people on the ground, keep on working on the ESG risks, et cetera. We still believe that this is an attractive project for Guinea, for Rio and for all stakeholders. Thank you.

And the next question comes from the line of Lyndon Fagan from JPMorgan.

I was just wanting to focus a bit more on the iron ore business and specifically, the time. A 133 million tonne run rate is an extraordinary amount of capacity to tie in, in 1 year. I'm just wondering whether you can reflect on the timing of all that and why it's all landing in this year and what that does in terms of creating risk to 2020. So I'm just wondering if some of that actually does flow into next year and whether you can talk through some of the risks for 2022.

Lyndon, thanks very much. So we always have talked about 2020 and particularly 2021 as being challenging years for the Pilbara because we've been constrained on mine capacity and also because we are bringing in a lot of replacement capacity this year, plus at the end Gudai-Darri. So that was always sort of in the plan, if you like.

Bringing in those tie-ins, I think we will be doing that progressively through. Clearly, that means that we have -- do have plant shuts as we have to undertake those tie-ins. We do have to synchronize all that very carefully. I think for the first half of the year, we've moved forward those projects. Slightly behind where we wanted to, but not well behind. I think we feel we're sort of now well placed for the second half of the year to finalize that work and tie in those 90 million of capacity.

Very different clearly from Gudai-Darri, which is a whole new hub. And there, we haven't got the same degree of, I think, time risk that we have when we're looking at the 90 million tonnes. And clearly, the other overlay here has been COVID. I mean it has been a constraint on us getting the right sort of labor and sort of support there to do some of that work. But again, I think in the first half, we've learned how to manage that much more effectively, and we'll take that experience into the second half.

So Lyndon, I think in summary, this is really predominantly a 2021 issue. As we go into 2022, we're really just looking up at the ramp-up of Gudai-Darri as the major piece, which will be progressive throughout 2022. Thanks for the question.

Yes. No, look, if I may just add on top of that. I think your question about why all these activities this year. Well, it's capital decisions that were all taken before we knew about a pandemic would hit the world, before we had the issues in the wake of Juukan Gorge and renegotiations with the traditional owners, et cetera. So I feel for the iron ore team. It's a lot of workload on them, but I actually think they're coping with it very well. We are, by and large, moving things forward to schedule. It's pretty impressive. And for sure, the iron ore business will be a stronger business when we have completed those.

And just a follow-up on the second half production. So I guess we've just seen a June quarter that was below the March quarter, which is fairly unusual. And I guess it doesn't set up the business well to hit the top end of guidance certainly. I'm just wondering how confident you are around the 2021 production guidance being met. And if you can maybe shed some color on how run rates are looking even through the month of July, just to give us a bit of comfort.

Lyndon, thanks. So I mean the second quarter was very unusual. And we were still seeing rain in the Pilbara well into May, a very green period when that shouldn't have been the case. And a lot of that was also in the mines that really did, I think, have an ongoing sort of effect. So the second quarter was unusual from those angles with the compounding effects, as we've talked about, around sort of COVID and the loss of some of those tonnes to managing carefully our sort of heritage risks on the ground.

I think we feel much more confident about the second half. I mean that's where our plan takes us, to be at the low end of our guidance range, as we've talked about. I think a much clearer run into the second half from a number of different angles that held us back in the first won't in the second. But also, we have been very clear that there are risks. There are risks around tie-ins. There are risks around COVID still there. But our plan is to do that. And if you look at the last sort of 5 years, that's the average of what we've delivered. It takes us into guidance. Thanks, Lyndon.

And the next question comes from the line of Paul McTaggart from Citigroup.

So I just wanted to ask about aluminum, which you highlighted today has been a good turnaround business. Do you see this in the future as a potential growth business? Let's assume China puts in place production caps, maybe get it back to being a net import position. And would you have enough capacity within your hydro system to enable that business to grow?

Yes. Thank you. That's an excellent question, and that is exactly what you should expect from us, of management, to explore all avenues. It's been a tough, tough years for aluminum, and isn't it great to see how it's coming back. We have probably the best western -- the biggest and the best western aluminum business in the world. And now in good conditions, you suddenly see double-digit return on capital employed and strong free cash flow. So we have to ask ourselves that question.

I don't have an answer for you on that today. I'll be happy to elaborate more on aluminum when we come to our capital markets in the fourth quarter. But right now, we should be happy about the operational performance in the refineries and the smelters. I have to admit, we can still do better on our bauxite business. So certainly, even in this price environment, we can do better. And don't forget, we have seen a progressively improvement in profitability over the year, much stronger performance towards the end of the second half than in the first half -- sorry, second quarter than in the first quarter. So it is really nice to see some major, major world-scale business we have here, and it's coming in very strong. Thank you.

The next question comes from the line of Myles Allsop from UBS.

Great. Could you just provide a little bit more color around Oyu Tolgoi? I'm surprised. Obviously, the undercuts have not happened so far. When does that undercut have to be made to meet the October '22 kind of start-up deadline? And how much -- if it is delayed, every month, what does that mean in terms of CapEx overruns for Oyu Tolgoi and yourselves?

Peter, do you want to elaborate?

Yes -- no, Myles, thanks very much for the question. I mean, I think it hasn't happened not because of the technical project. The technical project is in good shape. We've pretty much finished all the work necessary to undertake the undercut. But as we've consistently said, we do need all the approvals in place. We do need real certainty around power, and we do need certainty around funding. So we're still working through those issues.

It's been a pretty tough period in Mongolia. To be honest, with COVID, I think it's probably -- it's been incredibly hard hit. So following the presidential election, we've had COVID. We now need to enter those discussions with the government. And I think it's in everyone's interest, this moves towards the end game as quickly as possible and that's certainly our firm foundation. And that's where Bold and his team on the -- will be aiming as we sort of negotiate this through with the government. Thanks very much, Myles.

And what is the biggest challenge? What's the biggest kind of area of contention do you think today with Mongolian government?

Look, let me just say a couple of words here as well. You all expect us to have a very clear time line, but it's a real tragedy what is happening with COVID right now in Mongolia. It's one of the hardest -- they manage cover it extremely well last year, but sadly they have got it inside and they are one of the hardest hit countries in the world. It's not very helpful for us to try to hammer through a time line, and we can't do that in any case. We're doing everything we can.

The good news is they've gone through their presidential elections. There is parliamentary stability. And we have a shared goal, all wanted to move forward at Oyu Tolgoi. And obviously, we will do it as fast as possible. But we just have to recognize that there are a few things over and above that, including the health situation in Mongolia.

And the next question comes from the line of Robert Stein from CLSA.

Just a question on capital allocation. So obviously, with the large dividend payments and the slide in the pack around peak indebtedness in the second half at around $6 billion net debt, noting if commodity prices hold or diminish somewhat in the second half, there will still be a lot of cash generated and gearing levels, which are traditionally very conservative. When can we expect to see that, that conservatism basically being unwound? Do you think of it as a contingency for other unknowns related to COVID or commodity price volatility? And once those resolve, you're going to release the cash to shareholders? Or is it a war chest for future M&A? How should we think about that big cash balance that's sitting there?

Look ,you should not think about war chest, et cetera. You should think about that it's very helpful to have a strong balance sheet. We like to take business risks, but we don't like to play [Hasak] with the balance sheet. And the fact that we now have got a strong balance sheet, we should all be very, very happy about. I have always said that I'd rather try to be countercyclical than pro-cyclical. If you have a debt target, you have a definition procyclical.

Okay, right now, we have a situation of a little bit of net cash. I have actually spoken about that in my previous job as CFO, where I said, if we have to have net cash for a couple of quarters, fine with that. But of course, it is the discretion of the Board to pay out more dividend. And that's what -- if you listen to Peter's presentation, you saw as well, we have had the highest payout ratio of an interim result ever, not only in absolute sense, it's a record, but also the payout ratio of 75%. And there, of course, we have looked towards the fact that we have net cash.

But we don't have more net cash than when we pay the dividend, we will be back in net debt again and who knows how the second half will go. So please, yes, we like to have a conservative balance sheet, but it's not that we are trying too hard to either bad times or major M&A watches. Quite frankly, whether we pay the one dividend or the other dividend, we would be able to finance an acquisition. But right now, as you know, the 4 priorities, the main focus is on organic development of the company. I'm not ruling out anything on M&A, but I don't see any big M&A on the horizon right now. Thank you.

And the next question comes from the line of Tyler Broda from RBC.

Great. I guess this question I have is on inflation. Obviously, you've got the strike that started at Kitimat, Escondida potentially going on strike. You see, in the first half, it was $131 million of inflationary pressure, it was about 1% against the cost base. I mean how are you factoring inflation here into your guidance? And I guess from a more broader basis, are you starting to see more sticky inflation come through? Or is it still mainly just commodity price inputs that have been changing the mechanism on costs?

Thanks, Tyler. I mean I think there's sort of various levels here. Firstly, what we have seen is that normal cyclical change with prices that we see in the cost base. So we've seen the exchange rates move. We've seen some of the input prices and raw materials move. The energy price, the diesel price move. Those are -- I just sort of term normal sort of pressures on the business.

Secondly, we've had additional pressures due to COVID. I mean COVID has both given additional direct cost, but it's also put pressure on labor. We've talked about that in terms of the Pilbara and in terms of Mongolia. It puts pressure on our ability to allocate labor, if you like, and bring the right resources to work as we need to do it.

Thirdly, yes, in these times, we will always see a bit of pressure. Have we seen too much to date? Not too much. Will it transpire into a sort of higher sort of rate in the second half, potentially, because these are pretty, pretty strong markets that we're seeing at this moment. So Tyler, that's how I would see it at this moment in time. But right now, it's normal cyclical plus COVID. But potentially, we will see some extra sort of challenges as we get into the second half of the year.

It goes without saying, Tyler, that we see a little impact that steel has become more expensive, but somehow we accept that.

And the next question comes from the line of Alain Gabriel from Morgan Stanley.

Yes, I have a quick follow-up question on Jadar, which you guys have approved yesterday. How should we think about the IRR of that project? And what kind of pricing assumptions are you baking in, which helps us think a bit further into your approval process and the mindset of how you put these projects like Jadar and Simandou in the future?

Yes, thanks. That's probably beyond my competence. That's exactly your job as analysts in the market. But let me try to offer you the helping facts because we are not giving you any price guidance nor IRR. But I would say about Jadar, first of all, what I like with the project is it's a lithium project at scale with a very high grade. And therefore, we can see that we can come in right at the bottom of the cost curve. I like that.

Secondly, with the kind of lithium growth you have, we say 25% to 35% over the next 10 years. It's massive. I mean less than every 4 years, you have a doubling of the world market. So you do need a lot of new lithium. Look, where the lithium price will be, I don't know, it's probably going to go up and down a lot. But we just think over time, it will make sense. For us, when we look at it in various scenarios, it's going to be an attractive investment stand-alone. And even though it's a greenfield site, where you often have limited or pressure on profitability, it actually looks like a very valuable project. Thank you. Good luck with your modeling.

And next question comes from the line of Jack O'Brien from Goldman Sachs.

I will take the next question. And the next question comes from the line of Sergey Donskoy from Society Generale.

I have a small follow-up on your CapEx outlook and Pilbara development. At the moment, if I understand it correctly, replacement CapEx in Pilbara total is about $2 billion per annum for the period of 2021 to '23. Now do I understand it correctly that when you have all of the new replacement projects, Gudai-Darri and Western and others ramped up in '23, we should expect this number to fall pretty sharply from '24, maybe to the levels we saw in around 2018, 2019?

Sergey, if you look at our CapEx chart, we actually try and highlight the level of replacement spend. And in fact, what we see is the current sort of sway the projects in the Pilbara sort of finished this year with a tail of spend into next year. But then from '23 and '24, we are into the next sort of phase of development around other projects. Western Range, Gudai-Darri would be sort of looking at what next. So we will be studying those now and looking to sort of spend into that period of time, '23, '24 period.

What I think is sort of as the best sort of outlook is to think about that $2 billion. In those years, we will need to spend. It's a big system, we need to keep on bringing that replacement capital. And it's those years we will have to spend more again.

I see. So just to understand, this is not a situation where you will have some lumpy topics in some years and then some lean years when you spend much less. So $2 billion is like kind of a run rate that we should expect for the medium term. Is that correct?

For those years, I would say that's the best sort of outlook we would have.

And the next question comes from the line of Carsten Riek from Crédit Suisse.

Just coming back to the iron ore operation. You mentioned both you want to become, again, the best operator. My kind of big question is, how do you want to achieve that? Because your big Australian competitors seem to be ahead of Rio Tinto with regards to operational performance already for a number of quarters. Has your more diligent cultural heritage approach after Juukan Gorge impacted actually your mine plan in the Pilbara more than originally thought, what would you change not only to catch up but to become better?

Well, thank you. I -- my focus is on Rio Tinto's iron ore business. It's right now the world's largest iron ore business. And you can do better. And that's management's job is to do as well as possible. I'm not going to put any numbers up here because, as you know, every mine, you have different cost structures, everything is different. But we can see that there are certain operating practices where we can do better, and that's what we are trying to address in a very systemic way with implementing the Rio Tinto safe production system.

It's not about improving next quarter, it's about improving over time. It will take time, and we will gradually improve and bring ourselves back to where we were for many, many years as the best operator. But we are recognizing our weaknesses and addressing them and actually seeing a huge opportunity here. So we're not shy of it. And if there are some competitors who are doing better, I don't know, but congratulations to them. Our focus is on Rio Tinto it's a great business, and we can do even better. Thank you.

And the next question comes from the line of Jatinder Goel from BNP Paribas.

Just a question on lithium actually. There was some media speculation that Serbia is looking for potentially downstream processing requirement in country before they grant permits. Where are we on that journey? And do you have visibility on where the downstream processing will happen? And related to that, is lithium of your inorganic or M&A optionality list now with Jadar going ahead?

So look, thank you. I think it's important, first of all, to remind ourselves that Jadar is, in a way, both upstream and downstream. It's a mine, but it's also a chemical processing plant. So we are producing battery-grade lithium carbonate. So there's quite a lot of manufacturing involved. But I have to say, Rio Tinto is not in battery manufacturing nor are we in manufacturing of electrical vehicle. But I have a lot of sympathy for what Serbia is saying because in 2026, with Jadar up and running, we will probably be producing around 90% of the lithium being produced in Europe. So it would probably make sense and we are very happy to help and contribute to that. Because at some stage, we will have to start thinking about where should we sell our lithium. But right now, it's about building the mine, getting the permits, getting everything in line, building the mine, building the processing plants. And then I'm sure that there will be many interested in buying our high-quality product. Thank you.

And the next question comes from the line of Tony Robson from Global Mining.

Another follow-up on Jadar, I'm afraid, I apologize. 160,000 tonnes of boric acid seems fairly large, sorry, BTi for units relative to your existing California business, which is quite profitable. It's obviously a much more stagnant market than lithium. Is there any risk that you -- that's too much borates going into the market and that you're pushing prices down? Or will the slower ramp-up offset that?

Yes. Thanks. It's a good question, but you say it's a very stable market, but my latest prediction is that the demand for boron is going up by 11% this year. And I actually think it's a product that can be organically grown in a number of segments. So I'm not too worried about that. We are already the world's second-largest producer of boron and will become bigger, but it is a growing market. So -- and this is one of the real attractiveness of Jadar, is, yes, we are saying it's a lithium business, but it has got a very important byproduct of boron. And that, of course, pushes it significantly down the cost curve. So it's -- for me, it's an excitement. But yes, we do need to stay agile and making sure that we are able to sell the boron we are producing. Thank you.

And the next question comes from the line of Peter O'Connor from Shaw.

I've got the most objective question, it relates to trust. You've been -- and I acknowledge you've been in an enormous amount of work over the last 6, 9 months. In this regard, you've been refilling the trust bucket a drop at a time. Could you just outline us where we are on that journey to win back trust and social license? And what milestones and markers we would see or be able to acknowledge that you want to expect?

Yes. Thank you. I'll do my best, but you heard me saying in the presentation that our social license is judged by others, not by ourselves. So I'm probably the wrong person to ask. But I can put my hand on my heart and saying I and our new executive team have done our utmost and we certainly have made a step change in the level of engagement activities. I also think we have changed the way we are engaging.

But trust is -- you cannot demand trust of other people, it takes time. And I think we have had a good start. But what we need to demonstrate is an incredible consistency now. So we are on a journey. I think it's heading in the right direction. But to claim any success right now, that would just be wrong of me. Difficult question. Thank you.

And the next question comes from the line of Luke Nelson from JPMorgan.

Just another one on CapEx and the guidance to 2023. Can you just give us a sense of how much or what proportion of that is linked to sort of raw material imports, for example, flat steel? And in turn, how much of that is fixed pricing? Just trying to get a sense of potential risk going forward. If some of these inflationary effects hold, what the risk is into that midterm guidance?

Luke, thanks very much. I probably couldn't give an answer exactly how much is steel. But when you think about it, the component parts. I mean, we have -- we said 3 to 3.5 as sustaining and then the replacement spend and then growth. I mean it will be different from each project. But clearly, when steel comes through, it does make a difference. When exchange comes through, it does make a difference. But what we're looking to do is manage that within the envelope of our guidance that we've given out.

And to the extent that we do see any of these building blocks that have come in and change that, we will review that more fully. But for the moment, we're comfortable with our guidance. Thanks, Luke.

And the next question comes from the line of Kaan Peker from RBC.

I just wanted to ask about the sales mix in the Pilbara. We've seen (inaudible) Rio's lower grade product become a larger share of the product mix over the last year, particularly in the last 6 months. With low-grade discounts elevated, I would think that this is probably not a conscious decision. But could you please talk through why the lower-grade product has increased? Is it because of the operational issues Peter has mentioned in his presentation? And how should we think about it into the second half?

No, thanks very much for the question. So it really was a function of those challenges that we had in the first half, which meant that we were sort of looking at our mine plans on a pretty regular basis to just work things through and make sure that we were coping with those forces that were around us that I've sort of talked to. So we did have over 12 million tonnes of SP10 product in the first half, which was over -- just over double what we had in the first half of 2020.

I mean this will change just as we sort of manage our business going forward. But what I would say is that, again, when we come to the end of this year with Gudai-Darri, we do have more optionality in the mining portfolio. That's why this is so important. SP10, I think, will still be part of our product mix going forward -- as we move forward. But we do have that additional optionality that a new mining hub gives us. And then that's why we sort of -- we keep saying that it is a stronger business as we come out of 2021 into 2022. But thanks for the question.

And our last question today comes from the line of Paul Young from Goldman Sachs.

Jakob, can I ask a question on Oyu Tolgoi? I understand the challenges in COVID, but the disagreements with the government have been ongoing for years. So I was just wondering, what is the solution of getting the government to approve the technical study? And do you need to give up something within the current investment agreement?

So you're absolutely right. There is many, many solutions here. And therefore, I'm not being conclusive, particularly not when I speak on an open line. We -- the issue is quite simple. It's complex, but it's simple. There is a huge mutual interest. It's so much in the interest of the country of Mongolia, the government of Mongolia and Rio Tinto that we progress this.

It is a very valuable development. It's an impressive industrial development, and we need to find each other. And it starts with building the right relationships. And I think Bold and his team have done an amazing job and have really, really progressed that in the first half. But it has been difficult because you have also had a presidential election and that means you have some uncertainty, parliamentary uncertainty. That's over now.

But as I said earlier on my -- the earlier question, it's a real health strategy that you're faced with. I mean it's like no one, no place else where we operate, where we are so constrained on COVID as in Mongolia right now. And I'm, therefore, confident that we will find each other and we'll find solutions. What those solutions, I don't want to speculate in here. And the problem of not being able to give you a time line, is it really depends on how can we -- when can we get some quality time with the government and progresses. I'm absolutely convinced we will find each other.

We want to be there. We want to be a partner of the government, and we want to be a valued partner of the government and want to contribute to the country of Mongolia for the long haul. And that's where we will end up. I'm absolutely convinced about that. But Paul, I'm afraid I can't give you a time line in these COVID times here. Thank you.

That was our last question. Please continue with your closing remarks.

Well, there's nothing more to say than thank you very much for listening in here today, and we are looking forward to continuing the dialogue as we go forward. Thank you. Bye.