How Fortescue outsmarted BHP and Rio

First the good news. Fortescue Metals Group has teamed up with Brazil's Vale to sell more iron ore to China.

Now the bad news. Fortescue Metals Group has teamed up with Brazil's Vale to sell more iron ore to China.

How one deal can be good and bad at the same time is one interesting aspect to the joint venture revealed this week by the two companies.

What the two big miners propose to do is combine some of the ore they mine in Australia and Brazil at a new facility in China with the aim being to produce up to 100 million tonnes of blended iron ore products that meet specific requirements of steel mills.

As part of the deal, the big Brazilian miner will also be encouraged to buy a stake of between five per cent and 15 per cent in Fortescue, effectively becoming a new cornerstone investor in the Australian company.

A number of questions have been raised about the transaction, apart from the curiosity triggered among stock-market regulators over trading in Fortescue shares.

The first question is the potential effect on Australia's top two iron ore miners, Rio Tinto and BHP Billiton. The second is how a Fortescue/Vale tie-up will be received in China.

The good/bad aspect is easiest to understand because the proposal to blend low-grade Fortescue ore with higher-grade Brazilian ore at a jointly owned facility in China means that both companies can, in theory, snatch a bigger share of the Chinese market.

Unfortunately, what's good for Fortescue and Vale will not be good for the price of iron ore because the last thing the market for the steel-making material needs is an extra source of supply, especially at a time when Chinese steel production is falling.

Despite the recent sharp rise in the price of iron ore, and an equally sharp rise in the Fortescue share price, the reality of the iron ore market is that glut conditions remain and much of the recent rise can be explained by short-term steel-mill restocking.

Once stockpiles in China are full the mills will withdraw from the market taking the iron ore price with them, which is exactly what they hope to achieve.

Having helped engineer a flood of iron ore the mills are keen to enjoy a prolonged period of abundant supply to keep their input costs low at a time of falling demand for steel.

Any analysis of the Chinese economy will reveal how it is switching from a construction phase of growth to a consumption phase, which leads to the logical question: does China actually need more iron ore?

The answer is an obvious no, yet that's exactly what Fortescue and Vale are proposing to do though in order to achieve that objective they will have to knock someone else out of the market, which is more bad news for high costs producers.

Rio Tinto and BHP Billiton are not high cost producers and will probably not sacrifice market share to the new Fortescue/Vale alliance, but they will feel price pressure from any extra material being delivered into the Chinese market.

The Chinese Government, which might approve of extra iron ore to maintain downward price pressure on an essential raw material, will not be impressed with two existing suppliers teaming up in what might be seen as first steps towards cartel-like behaviour.

But, the issue which must be of greatest concern to investors is that Fortescue appears to have yet again outsmarted BHP Billiton and Rio Tinto by finding a way to ensure its own longevity at a time of excess commodity supply and low prices.

Just over a decade ago the two biggest Australian iron ore miners failed to understand the threat Fortescue represented, preferring to mount a whispering campaign against the heavily indebted newcomer rather than launch a rapid increase in their own production to prevent Fortescue from snatching market share.

This time around BHP Billiton and Rio Tinto have been guilty of believing that they can beat Fortescue on cost cutting, raising production and sacking staff to achieve productivity improvements that Fortescue has matched every inch of the way.

Now the big two are being forced to watch Vale, the world's biggest iron ore producer, secure a toehold in their backyard, bringing a skill set and marketing clout that Fortescue lacks.

While the immediate outlook is rosy for iron ore the longer-term picture is clouded by persistent increases in supply being delivered into a falling market.

What that means is that while Fortescue might look like a winner today it will become a loser like everyone else in the iron ore sector.

As for BHP Billiton and Rio Tinto there must be red faces in its executive ranks for not seeing a Fortescue/Vale connection and what it might mean to their business models.

In effect, the two big Australians were guilty a decade ago of allowing a “fox” in the form of Fortescue into their iron ore henhouse, now they're watching a second (Brazilian) fox steal their eggs.