Fortescue's blowout blip

There are some mixed signals within the June quarter production report issued by Fortescue Metals today. While the overall picture is a positive one, the jarring note was a $US600 million blowout in capital costs as the group pursues its extraordinarily ambitious expansion program.

The major factor in the increase in Fortescue's capital expenditure budget to $US9 billion as it ramps up its planned shipments from 55.8 million tonnes to 155 million tonnes next year was a $US500 million increase in the budget for its Solomon project.

Fortescue blamed design changes, general price escalation, delays in offloading equipment and increased housing costs for the increase. It also experienced a $US200 million increase in its spending on its port and rail facilities, offset by a $US100 million reduction in expected spending on its Chichester Hub project.

In the context of a $US9 billion expansion program, and in the inflationary environment all the big miners are experiencing as they scramble to increase production, a 6.6 per cent blowout in capital costs isn't by itself a major issue and, indeed, the market seemed to take that news in its stride.

The issue for Fortescue has always, however, been its debt levels as it has pursued a remarkably bold expansion strategy to create a third force within the Australian iron ore industry behind Rio Tinto and BHP. Fortescue has nearly $US6 billion of debt and still has, after the revised budget, another $US6.2 billion of capital expenditure to go.

It is the leverage in the group that has attracted the short-sellers and caused renowned short-seller, Jim Chanos, to nominate the group as a prize candidate for shorting.

Fortescue itself is sanguine about its debt levels and believes that its $US2.3 billion of cash, existing facilities and cash flow from operations will provide adequate funding for the expansion.

Nevertheless, it also says it is in discussions about funding the $US600 million increase in its capital expenditure budget and maintaining its overall liquidity levels.

While the escalation in costs is a discordant note, there was plenty of positive news within the report.

In the June quarter Fortescue shipped a record 17.8 million tonnes of ore, 42 per cent more than in the March quarter and sales for the 2012 financial year were, at 55.8 million tonnes, 40 per cent above the prior year's.

As production has increased, costs have decreased. Average cash costs of $US46.04 a tonne were 12 per cent lower than in the March quarter and compare with the full-year average of $US48 a tonne.

The appeal of the expansion can be seen in the comparison between those declining costs and the $US125 a tonne average sale price. Iron ore prices might be well down on their peak, and unlikely to return to those levels with China's economy slowing and more supply entering the market but there is a big margin for error built into the economics of the expansion, which will see the group produce about 86.5 million tonnes this financial year and end 2012-13 at its targeted run-rate of 155 mtpa.

Fortescue's chief executive, Nev Power, has indicated that the group will take a breather from its expansion plans once the Solomon project is completed next year. It is already, however, looking at future expansion and has both further identified resources and a massive exploration portfolio to support future expansion projects.

If all goes according to plan Fortescue will become significantly cash flow positive once the current capital expenditure program ends. Unless it immediately embarks on another big spending spree, that would give it ability, for the first time since Twiggy Forrest launched the group nearly a decade ago, to deleverage and get the bankers and short-sellers off his back.