Fortescue’s ferocious growth flip flop

Restarting work on the Kings development sees Fortescue return to its ambitious former self. With the shackles of debt loosened and iron prices back on the up, Andrew Forrest is moving back to expansion mode.

Only an entrepreneurial and entrepreneur-dominated company like Fortescue Metals could execute the flip flops in strategy it has experienced in the past few months without igniting a sharemarket backlash.

A little over three months ago Fortescue was teetering as the iron ore price collapsed below $US90 a tonne, and forced to can an ambitious expansion plan, slash costs and sell assets to slow the aggressive build-up of debt on an already debt-laden balance sheet.

Today it announced that development of the Kings project, mothballed in September to defer $US1.6 billion in capital expenditures, would resume next month.

Completion of Kings would, with the existing development of the 20 million tonnes a year Firetail deposit, lift Fortescue iron ore output by about 60 million tonnes per annum to 155 mtpa. It will establish the group as clearly the third force among the Australian iron producers, behind Rio Tinto and BHP Billiton, albeit that those companies have much higher quality and far lower cost Pilbara operations.

Fortescue has been able to return to its original ambitious expansion program not only because the September price shock forced it to sell some assets, reduce its costs and restructure its borrowings, but because the iron ore price has rebounded.

It would also be comforted by the process it has started, and which is said to be generating considerable interest, to sell a substantial minority interest (about 40 per cent) in its rail and port infrastructure, which should raise several billion dollars at least (there are some very heady numbers floating around) to lower Fortescue’s peak debt from an estimated $US12 billion in the absence of a sale.

The iron ore price has bounced back faster and more strongly than anyone had expected. While still a very long way off its highs of nearly $US200 a tonne, at the $US135 or so a tonne at which it is currently trading Fortescue’s mines would be strongly profitable.

The price has recovered from its lows partly because China’s growth rate appears to have stabilised and the destocking cycle that forced the price below $US90 a tonne has ended.

There has always been a view that, beneath the noise created by the inventory cycles of the Chinese steel mills there is a floor price for iron ore around the $US110 to $120 a tonne range created by the cost bases of the higher-cost Chinese producers.

The September plunge in the price and the still-escalating development and operating costs within the Australian resources sector means that a lot of proposed new supply has now been deferred indefinitely and perhaps permanently, having missed the boat that Forrest caught by racing to get his original mines into production while the price was at record levels.

That disruption to new supply will help stabilise the price at levels that are high by historical levels even if the more moderate growth rate expected for the Chinese economy, the more subdued outlook for its steel industry created by both the weak global economy and changing composition of growth within its own economy do eventuate.

For Fortescue, the significance of Kings is not just that it adds 40 mtpa of production but it is low-cost production that will help strengthen the group’s economics and ability to weather any further bouts of price volatility and swell the cashflows that will enable it to further reduce its leverage and the vulnerability that creates.

Fortescue would also be mindful that if it sells a big interest in its infrastructure assets it will – because of the need to give the buyer/investor an adequate return – inevitably increase its operating costs by more than the savings it makes by reducing its borrowing requirement. The Kings production will help to muffle that impact.

Fortescue’s decision-making might appear erratic but its logic is quite sound and the abruptly revived dash for growth sensible as long as the iron ore price holds around current levels.

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