How Fortescue became a victim of its own success

As the higher-cost of the major seaborne producers, Fortescue Metals would have expected to come under increasing scrutiny and stress as the iron ore price keeps falling. As the consensus builds that the market for iron ore has gone from 'stronger for longer' to 'lower for longer', it will come under rising pressure to respond.

Fortescue shares fell more than four per cent today, to just over $2, after the iron ore spot price sank to another five-year low of $US63.54 a tonne overnight. Less than 12 months ago, Fortescue shares were trading at just under $6.

There's nothing complicated about why Fortescue is getting hit hard by the price declines. Among the bigger seaborne producers -- Rio Tinto, BHP Billiton and Vale are the others -- it has the highest costs and the most financial leverage, with nearly $9 billion of debt.

While Nev Power has done a good job of both reducing costs and leverage -- Fortescue says it reduced its all-in costs by 23 per cent last year and it has repaid about $US3.6 billion of debt over the past two years -- in something of a perverse outcome Fortescue has become a victim of its own success.

By racing to an annual production rate of 155 Mtpa from a standing start six years ago, Fortescue turned itself into the fourth-largest of the major seaborne iron ore producers. The way the market has developed since the iron ore price cracked, however, that seems to have effectively made it the marginal producer.

That shouldn't have been the case, but two developments have conspired to put the squeeze on the group.

One, well-understood, is the response by Rio Tinto, BHP Billiton and Vale to the collapse in the price.

They have dialled up their production volumes dramatically, and are continuing to add to their output while also carving into their already low-cost bases. Volume increases and cost reductions are blunting the impact of the price declines.

The impact of their increased production has been to create a growing surplus of seaborne supply over demand as the growth rate in China's demand for iron ore has slowed.

The most visible casualties of the dive in the price and the rising over-supply have been smaller higher-cost miners, the latest of which was Arrium, which announced the closure of its Southern Iron mine last week. A lot of smaller Australian producers will inevitably disappear.

The most logical source of supply-side adjust, however, should have been China's high-cost domestic producers.

While some of that domestic supply (about 400 million tonnes a year) has been displaced by the lower-cost seaborne volumes, not as much has been withdrawn as might have been expected. There would be some Chinese production that is competitive once transport costs are taken into account, but there's also an element of China's production where either it is integrated with steel mills or there are 'social' reasons for maintaining loss-making production.

In any event, where China might have been the marginal or swing supplier in the past (and probably still should be), it looks like Fortescue might have inadvertently inherited that role.

While it might be tempting to see the impact of the decline in the iron ore price and the swelling surplus in the market for seaborne iron ore on Fortescue's share price as an indication of crisis, it oughtn't to be -- at least not yet.

To their credit, Nev Power and Twiggy Forrest have, by attacking costs and prioritising debt reduction, dramatically reduced the extent of Fortescue's vulnerability. It is still vulnerable, but it would have been in deep strife today had it not been for the way they responded to an earlier scare in 2012.

Most importantly, Fortescue has no meaningful debt repayments until 2017. If it felt it necessary, it could exploit the current ultra-low cost and easy availability of credit to refinance its earlier maturities to push out its repayment obligations even further.

The slide in the Australian dollar and a significant reduction in shipping costs would also, along with its own continuing efforts to lower its costs, help blunt the impact of the price declines.

Fortescue has another option to respond to sustained lower prices that would see it adopt a very different strategy to that of the other big Pilbara producers. Instead of increasing volumes to increase productivity by pushing more volume across a lower cost base, Fortescue could cut production to increase its margins.

In a KGB Interview last year, Power made the point that Fortescue owns 100 per cent of its assets, both mines – four of them – and the rail and port infrastructure supporting them. In the past Fortescue has considered selling an interest in the infrastructure assets to reduce debt, which remains an option.

The more interesting option might, however, be to reverse its former volume-driven strategy.

A recent Goldman Sachs analysis canvassed Fortescue's options for responding to the plummeting iron ore price. Apart from carving into its capital expenditures and giving up any further growth ambitions, which the analysts thought could reduce capex by about $US800 million a year, they canvassed the option of closing one of the four mines.

Fortescue's Cloudbreak mine within its Chichester Hub has the highest costs and lowest quality of Fortescue's operations, Goldman said. Closing it and taking 40 Mtpa of output out, would reduce Fortescue's break-even cost by about $US7 a tonne to about $US64 a tonne.

If it had to, Fortescue could shut down the entire Chichester Hub complex temporarily, more than halving its output but would take significant volumes out of the seaborne market while also reducing its unit costs further, Goldman argued.

Fortescue may or may not exercise any or all of them, but the underlying point is that if it is becoming the marginal producer as China's supply-side response to the lower prices peters out, it does have the options that a marginal producer needs – the ability to both increase or decrease volume while surviving the low prices within of a cycle.

With its December quarterly report presentation due on Thursday, Power will have an opportunity to defend Fortescue's position and detail its responses to the new iron ore price environment.

Costs, cash flow and debt will be the market's focus now that the pervasive consensus is that sub-$US65 a tonne prices are the 'new normal' for iron ore and are likely to remain so for the foreseeable future given the rising glut of supply.