Fortescue accepts the oversupply reality

Only last week Fortescue Metals' Nev Power was expressing confidence that the group's ambitious and largely debt-funded $US9 billion expansion program was on track despite the steep fall in iron ore prices. Today he carved more than 25 per cent – $US1.6 billion – from the remaining $US6.2 billion of that program.

He also foreshadowed job and other cost cuts that will, he says, save about $300 million and lower costs from Fortescue's existing operations but the key decision has been to scale back Fortescue's planned increase in production from its original plan to get to a rate of 155 million tonnes per annum next year to a more modest 115 million tonnes per annum.

Fortescue is currently producing at a rate of just over 55 million tonnes but expects output of between 82 million tonnes and 84 million tonnes this financial year, between 2.5 million tonnes and 4.5 million tonnes less than it had previously envisaged.

Fortescue is also in negotiations to sell off some non-core operations, saying it was in "advanced negotiations" to sell its Solomon power station and was also discussing the potential partial sale of its North Star magnetite project.

What led to Power's change of heart and the sudden sense of urgency inside of a week? It may have something to do with the fact that the spot price for iron ore, which has been in free-fall in recent weeks, fell just below $US90 a tonne overnight. A year ago it was touching $US190 a tonne.

Fortescue, which had $8.5 billion of debt at 30 June, subsequently topped up with another $US1.5 billion raising, planned to supplement the additional borrowings it would need for the $US6.2 billion of capital expenditure remaining in the expansion program with cash flows from its existing operations.

The continuing dive in the iron ore price, however, would have caused Fortescue to consider what might occur if the price didn't recover in the near term and what that would mean for its cash flows and its capacity to service debts that would probably have peaked at more than $US11 billion next year. It also has to factor in its ability to meet a $US2 billion principal repayment in 2015.

In the circumstances, the only sensible decision to make was to halt the spending, or at least as much of it as was possible. This financial year Fortescue will still have to fund the remaining $US4.6 billion of capital expenditures to complete the expansion of its Christmas Creek mine and processing facility, commission the Firetail deposit at its Solomon mine and finish the supporting rail and port infrastructure.

Fortescue, as one of the more advanced of the new wave of iron ore producers in Western Australia, won't be the last of those new producers or aspiring producers to be forced to severely cut back on their ambitions and production, if they have any. Projects that were compelling when the iron ore price was solidly above $US150 a tonne don't look feasible at prices below $US100 a tonne.

It would not be a bad thing for the industry longer term if that prospective, much higher-cost and lower-quality production were shut out of the market by the lower prices.

A factor in the magnitude of the decline in iron ore prices is that, after being delayed by the financial crisis, there has been a very significant ramping up of supply in the past year as new projects and the expansion projects of Rio Tinto and BHP Billiton have progressively come on stream.

With that big boost to supply coinciding with the weakening of China's growth rate and the demand for steel as the economic issues within Europe and the US have hit its two major export markets the growth in demand for iron ore has fallen back, with an exaggerated impact on the spot price.

With China's steel mills sitting on (and now depleting) significant inventories and starting to make production cutbacks of their own but its own high-cost domestic iron ore producers yet to be forced out of the market the market has shifted from the balance that under-pinned the resource sector's "super-cycle", where supply was lagging demand, to one where the market is oversupplied.

Without more cuts to planned expansion and greenfields projects the rate of growth in supply will continue to be multiples of the likely growth in demand – even if China can put a floor of 7.5 per cent or so under its economic growth rate – and ensure that iron ore prices, even if they do recover as the mills' inventories are run down, remain closer to $US100 a tonne than the $US200 a tonne they approached last year.

Apart from Rio, BHP and Vale, there aren't many of the new producers that would, after funding costs are added, have economic projects at sub-$US100 a tonne price levels. The bulge in new supply that had been expected to bring the market progressively into balance by the middle of this decade may, now that that balance appears to have been achieved a couple of years earlier than anticipated, not materialise.

Even BHP recently shelved its planned $US20 billion Outer Harbour project at Port Hedland in response to the tumbling prices, while Rio has made it clear it will be more cautious about how it sequences its own further expansion projects.

There should, in theory, eventually be something of a rebound in prices given that below the $US100 a tonne level the price would be solidly below the costs of the Chinese producers that ought to be the major determinant of the market-clearing price levels.

Unless China can really fire up its growth rate, however, and there is some kind of meaningful recovery within the global economy, the continuing increase in supply that is already within the pipeline should keep a heavy lid on the prices.