Fortescue's statement of intent

A relatively small deal for Fortescue has got the market excited. That's because it signals the iron ore giant's genuine commitment to becoming a volatility-proof volume producer.

It’s curious that Fortescue Mining today announced the sale of a 25 per cent interest in a relatively small iron ore mine, and the prepayment of some infrastructure access charges for $190 million, and its market value rocketed ahead by nearly $900 million.

Actually, the 7.5 per cent spike in Fortescue’s share price probably wasn’t all attributable to the deal it has struck with iron ore junior BC Iron, but that deal does appear to have been responsible for the larger part of the increase.

It helped, given how leveraged Fortescue is to iron ore prices, that the spot price for iron ore jumped $US3 a tonne to $US121 a tonne, but the sale of a 25 per cent interest in the Nullagine joint venture it has with BC Iron appears to have been the driver of the market’s enthusiasm.

That joint venture, which has the potential to produce about six million tonnes of ore a year, is not material to Fortescue but the sale sends a signal to the market that Fortescue is serious about cashing out some of its non-core interests in order to sensibly fund its core ambitions. Fortescue will retain a 25 per cent interest and also has a profit-share arrangement on additional tonnage if the iron ore price is above $US120 a tonne.

Fortescue bought into the Nullagine project in 2009 in a deal which gave BC Iron access to its rail and port infrastructure – a very smart piece of deal-making by the smaller company. BC Iron, which manages the joint venture, will now own 75 per cent of the mine, which is expected to export five million tonnes of ore this financial year and reach its capacity of six million tonnes towards the end of the year. It has also made a one-off prepayment of its rail haulage and port charges.

While $190 million isn’t particularly material in the context of Fortescue and its $12.7 billion market capitalisation it is a demonstration of Fortescue’s intent, and perhaps its desire for cash to fund its plans rather than the debt which it previously used as its option of first resort.

In September, when the iron price plummeted below $US90 a tonne in the wake of a slowdown in China’s economy and an over-stocked position for China’s steelmakers, Fortescue made some quite abrupt and radical changes to its expansion plans.

It slashed jobs and spending and shelved the final phase of an extremely aggressive expansion strategy that would have seen its output rise from around 85 million tonnes this financial year to 155 million tonnes in the next, scaling the target back to 115 million tonnes by mothballing the planned development of the Kings deposit within its Solomon Hub. That saved it about $US1.6 billion of capital.

It then raised $US5 billion to refinance its debt, using some of the proceeds to redeem a potentially very expensive form of funding from US private equity group Leucadia Capital, and said it would look at selling non-core assets.

The significance of Kings is that, with the Firetail project already underway, it could materially reduce Fortescue’s cash costs of production.

With it most unlikely that iron prices will go back to the stratospheric levels at which they peaked, a lot of new supply coming into the market and demand likely to be softer than the levels on which that new supply was predicated, the profitability of iron ore businesses will be determined by their ability to pump out higher volumes while operating within the bottom quartile of producer costs.

Fortescue needs those extra tonnes and lower costs from the Kings expansion but its recent experience will have made it far more cautious about adding to an already, by resource sector standards, high degree of leverage.

If it can sell non-core assets at reasonable prices to fund its expansion plans, as the BC Iron deal indicates it can, it would be better positioned to withstand future volatility in the iron ore price.

Fortescue founder Twiggy Forrest has made it clear that, circumstances willing, he’d love to put the mothballed expansion projects back on track by the end of next year. The deal with BC Iron was a modest but meaningful step towards that ambition, not to mention a very good deal for BC Iron as well.

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