Fortescue gets another wake-up call

Had Fortescue Metals not had a glimpse into the abyss in 2012 it would probably have been in deep trouble at this point, with the iron ore price dipping below $US90 a tonne and no obvious source of relief in sight.

While the 2012 fall in the iron price below $US90 a tonne was short-lived, it galvanised Fortescue into major debt and cost-reduction programs.

Where its C1 cash costs were above $US50 a tonne in September 2012, they are now around $US33 a tonne and falling. Its net debt peaked at $US12.7 billion last year and, after a number of early repayments, is now down to about $US8.6 billion.

If the current downturn in the price – it is about 34 per cent lower than its starting point this year and last year’s average of $US135 a tonne – is sustained, the question of whether Fortescue has done enough to reduce its costs and debt will be tested.

The group’s chief executive, Nev Power, has said Fortescue’s cash break-even point is an iron ore price in the low $US70 a tonne/62 per cent CFR range. Fortescue, with lesser quality ores than its Pilbara competitors Rio Tinto and BHP Billiton, receives lower prices than they can get for their ore with its higher ferrous content.

All of the Pilbara producers are ramping up their production volumes but increases in volume don’t compensate them for the lower prices, nor are they able to reduce costs quickly enough – although they are all significantly reducing costs – to offset the loss of margin.

There is a growing conviction in the market that slower growth in China’s demand for iron ore and the massive and continuing increases in supply are producing a growing structural surplus in iron ore, which would suggest that significantly lower prices will be a semi-permanent feature of the sector.

In the December half of this financial year, the price Fortescue received averaged $US124 a tonne. Power said earlier this year he expected prices that ranged between $US110 a tonne and $US120 a tonne for the rest of the year.

While it is possible, given where it was at the start of 2014, that the price might average around the lower end of that range in the June half, the outlook for 2014-15 isn’t promising and the pressure on Fortescue to continue to reduce costs would be mounting.

The group was strongly profitable in the first half, with earnings of $1.72 billion, but it does face some challenges given the still-high levels of debt it is carrying.

While it did lower net debt by more than $3 billion in that half-year, its cash flows for the period included $US712 million of prepayments for iron ore and a further $US500 million of pre-payments of port access fees.

In other words, it had the benefit of payments for future production and services to enable it to reduce its debt. That’s $US712 million of future production and $US500 million worth of port access fees that it won’t get when it ships ore and grants access to its port facilities in future. It also has a $US750 million tax payment due in December.

It is the continuing, albeit reduced, high levels of debt it is carrying and the combination of higher costs and lower quality ore that make Fortescue the focus of attention each time the iron ore prices falls below $US100 a tonne. Rio and BHP’s Pilbara operations can remain profitable at far lower prices than Fortescue’s.

Nev Power and Twiggy Forrest got their wake-up call in 2012 and so go into the current downturn in significantly better shape than they might have been had that relatively brief slump in the price not scared the living daylights out of them. Another 12 or 18 months of iron ore prices around last year’s average and they would have been in a much stronger position to deal with another slump in the market.

They’d now be acutely aware, however, that Fortescue isn’t yet out of the woods and that if the price remains at its current level or slides further for a protracted period – and the structural surplus thesis would certainly ensure that outcome – the residual debt levels within the group and the higher cost and lower quality of its output will remain a threat to its stability.

The obvious mechanism for raising a big lump of cash (if one is needed) without risking or diluting Forrest’s control of the group would be to revisit the infrastructure sale process that they reluctantly started in 2012 and then happily abandoned when the iron ore price rebounded within months.