Iron ore crush

PORTFOLIO POINT: Australian iron ore miners are receiving less for their ore and shares prices have fallen. Another round of falls could be on the way.

Investors exposed to the small end of the once-booming iron ore industry should brace themselves for more bad news, with the price received by most miners dropping through the psychologically important $100 a tonne mark.

When combined with rising costs, a sharp fall in the US dollar price for iron ore, the high Australian dollar, and a widespread misunderstanding about the real price received, it can be seen that profit margins are being crushed.

Stocks such as Atlas Iron, Mt Gibson Mining, BC Iron, and the leading pure-play iron ore producer, Fortescue Mining, have suffered share-price falls since earlier this year, but they could have further to fall.

Since hitting share-price highs in February, iron ore miners have declined by between 30% and 40% thanks to the fall in the officially-reported iron ore price from around US$140 a tonne earlier this year (and as high as US$180 a tonne in August last year).

However, the share-price falls, which have seen Atlas drop from $3.34 to $1.84, Mt Gibson from $1.46 to 98c, and Fortescue from $5.74 to $4.13 – might not reflect the accelerating decline in the iron ore price over the past eight weeks.

Since mid-June the US dollar iron ore price has lost another 20%, hitting a three-year low on Wednesday of US$113.50 a tonne, but even that is not the price that Australian miners get.

The first deduction in trying to work out what Australian iron ore miners get for their product is the exchange rate which, at US$1.05, cuts the Australian-dollar price to $108/tonne.

Then comes a much bigger deduction because the commonly-quoted US dollar price is for premium-quality material assaying 62% iron, which is how commodity-tracking agencies, such as Platts, record the international price which is known as IO62 (Iron Ore 62%).

Very few Australian miners are working deposits as rich as 62%. There are pods of material in that category (and higher), but the best ore has been largely mined out.

Atlas Iron, for example, reports on a grade of 57.5% iron, but that will vary from deposit to deposit, and from cargo to cargo. Mt Gibson quotes a grade of 60% iron, and BC Iron reports on 57% iron content in its orebodies.

What that means is that the widely-quoted Platts price on ore assaying 62% iron shrinks on conversion to Australian dollars, but shrinks much further on conversion to the grade of ore being sold.

As a rough rule, the real price received by Australia’s smaller miners shipping out 57% ore is about 87% of the Platts price, meaning that the current Platts price of US$113.50 (after the dollar conversion, and after the quality deduction), is closer to an Australian dollar price of $94 a tonne.

The problem for investors, investment bank analysts, and journalists, is that there is no uniform price for iron ore, because even that theoretical A$94 could be cut further if there are high levels of impurities, such as phosphorous, silica or alumina.

What can be assumed is that the days of iron ore miners talking about a price for their product being above $100 a tonne have gone, for now.

The falling iron ore price is one part of the problem. Rising costs are the other, and costs other than the widely-report “C1” cost of production is an additional issue for investors because the C1 cost does not include financing, depreciation and other charges.

BC Iron, in its June quarter report, disclosed a C1 cash cost for its iron ore of A$42 a tonne. Atlas reported that it was targeting cash costs of between A$47-and-A$52 a tonne for next financial year. Fortescue’s latest half-year C1 cash cost was A$54 a tonne.

All of the latest reports about prices received and costs incurred by the iron ore miners are from a trading period before the latest fall in the iron ore price, and while the true, total cost, of producing a tonne of iron ore will vary from company-to-company it is reasonable to assume that another 10% to 20% can be added to each tonne of iron ore.

At 20% in additional financing and other charges, a tonne of iron ore produced by Fortescue is closer to $64 a tonne. BC Iron’s true cost would rise to $50 a tonne, and Atlas Iron’s peak project cost for next year rises to around $64 a tonne.

It’s only when the true costs are considered, alongside the real price received, that the full scope of the problem bearing down on profitability in the iron ore sector can be estimated – though the full extent of the damage will vary from company to company.

For most iron ore miners the era of enjoying a profit margin as high as $100 a tonne has disappeared. The new margin is between $30 and $40 a tonne – still profitable, but nowhere near the boom profits of earlier years.

Two questions remain to be asked by investors and analysts.

Firstly, are current share prices accurately reflecting current earnings?

Secondly, is the iron ore price likely to recover soon?

The answer to the first question is “probably not” because since mid-June as the iron ore price was losing its latest 20% share prices did not fall in harmony, and some have even risen.

Mt Gibson, at 98c is around the same as its mid-June price. Atlas, at $1.84, is down by about 25c from its mid-June price of $2.10. Fortescue, at $4.13, is down about 70c from its mid-June price, and BC Iron, at $2.62, is up 10c from its mid-June price.

What appears to be happening is that the market is unconcerned by the latest sharp fall in the US dollar price for iron ore, and is possibly factoring in a price rise in the final quarter of 2012, an event being forecast by some analysts.

If the iron ore price does rise, profits margins will be restored. But, if the slump in Chinese steel production continues then the profit crunch could be very painful.

For some companies it means that a profit as high as $100 a tonne -- when the Platts 62% iron ore price was at US$180 a tonne and the Australian price (after currency and quality deductions) was close to A$150 a tonne – has shrunk to around $40 a tonne, and perhaps lower.

It is the shrinking profit margin caused by falling prices and rising costs which is also making it difficult to fund new projects.

Aquila Resources is the latest iron ore hopeful to scale back its mine-development plans, a step widely expected in the market which was slashed the company’s share price from $6.25 in February to recent trades around $2.22.

High-cost iron ore processing projects, which aim to upgrade low-quality ore (magnetite) into an exportable product, are also facing a torrid time, and even Australia’s richest person, Gina Rinehart, is scrambling to assemble a banking syndicate for her Roy Hill mine.

It would be unfair to suggest that the entire iron ore sector is in sell territory, but it would be wise to look closely for signs of a recovery in the Chinese steel market before expecting Australian iron ore miners to deliver the sort of stellar stock market performance of the past few years.