Iron ore: More to worry about than price

Rio Tinto, Fortescue and Mount Gibson are dealing with significant non-market events.

Summary: Mount Gibson has cut production after a wall in one of its mines started to collapse. Rio Tinto controls a business in Canada that has been affected by a train derailment, raising questions about whether Rio’s most marginal mines can stay profitable. Fortescue Metals Group is considering whether to diversify or remain a single commodity specialist. Meanwhile, a collapse in the iron ore price means miners are working hard to cut costs.

Key take-out: Costs and prices are just part of the iron ore situation. Other factors such as mine-site accidents and management disputes also affect mining companies.

Key beneficiaries: General investors. Category: Iron ore.

Yesterday’s fall in the iron ore price to a five-year low of $US71.80 a tonne has piled more pressure on high-cost miners, but it’s not the only issue making some investors nervous about the sector.

Three non-market events affecting Mount Gibson Iron, Rio Tinto and Fortescue Metals Group over the past month are reminders that mining is a risky business, and this year’s 47% drop in the iron ore price is just one factor in assessing future performance.

At the Koolan Island mine off the WA coast, Mount Gibson Iron has been forced to cut production after a wall in the pit started to collapse.

Repair work is underway but the timing of the incident could not have been worse and is a factor in Mount Gibson’s share price dropping to a 12-month low this week of 36.5 cents, a price which values the company at $416 million, or $49 million less than the company’s cash backing of $465 million at the end of September.

Compounding uncertainty about Mount Gibson is the way the severity of the pit wall problem has been reported by the company.

The original announcement on October 26 said the instability in the wall should not affect annual production and should be fixed in about four weeks. But on November 10 Mount Gibson said it would cut annual production and would take up to three months to repair.

In Canada, the derailment of a train operated by the Iron Ore Company of Canada has upset the operations of a business controlled by Rio Tinto and raised questions about whether all of Rio Tinto’s mines can remain profitable at a time of low prices.

One member of the train’s crew died in the incident on November 6 and while operations continue at IOCC it shone a light on Rio Tinto’s most marginal mines, which will be struggling to avoid losing money in a market flooded with low-cost iron ore, much of it from Rio Tinto’s low-cost Australian mines.

At Fortescue, some investors were dismayed to discover a boardroom split over whether the company should continue as a single commodity specialist or embark on a process of diversification.

Founder and chairman, Andrew Forrest, believes it’s time for Fortescue to add other interests to iron ore telling last week’s annual meeting that there were “mature” plans to diversify with oil and gas one of six possible additions.

Graeme Rowley, who helped create Fortescue in 2003, served as executive director of operations until 2010 and retired from the board last week, disagrees. He said after the annual meeting that Fortescue should “stick to its knitting” as an iron ore specialist.

It is impossible to know what direct effect a dispute about its future direction at the highest levels of management has had on the company’s share price but on the day of the annual meeting (November 12, 2014) when the different views surfaced, Fortescue shares fell to what was then a 12-month low of $2.91.

Fortescue’s fall continued today with a fresh low of $2.775 set in morning trade, taking the fall from its 12-month high of $6.22 to 55%.

The timing of Forrest starting a debate about diversification could not have been worse because of the poor state of the iron ore market and questions about the production cost and debt structure of Fortescue.

The debate about diversification versus specialisation is an old one in the mining industry.

Institutional investors prefer their miners to be focussed on what they do best so fund managers can allocate capital across a selection of specialist stocks at different times in the commodity-price cycle.

Some smaller investors, and some managers, prefer a basket of commodities in the same company so the capital allocation question can be handled internally.

What worries observers of the Fortescue situation is that Forrest is talking about allocating scarce capital at a particularly volatile time in the commodity sector, almost as if his interest in iron ore is fading and it’s time to do something else.

At a personal level Forrest is certainly embarking on a process of diversification having recently acquired a big beef producing business in WA (Harvey Beef). He is reported to be interested in acquiring a dairy business.

Adding oil and gas to Fortescue’s portfolio would significantly change the nature of the company and raise the critical question of whether it can afford to make such a move at a time when its iron ore profits are shrinking.

The tough time confronting all iron ore mining companies has been well reported in recent weeks, though regular readers of Eureka Report have been warned for more than two years that an iron ore glut was growing and would have a devastating effect on prices.

With the price collapse obvious to everyone today it becomes a question of what next and that’s when the game gets harder because the latest price of $US71.80/t for premium quality iron ore means that some mines are struggling to survive.

Analysts at the investment bank Credit Suisse earlier this month published one of the more sobering reviews of the iron ore industry which suggested that at the current price the only Australian iron ore miners operating profitably are Rio Tinto and BHP Billiton.

According to the Credit Suisse analysis Mount Gibson in the current half year is operating at an all-in (total cost) break-even price of $US104.50/t. Atlas Iron is operating at $US87.60/t and Fortescue at $US72.50/t.

Rio Tinto’s all-in break even cost is $US47.80/t and BHP Billiton is $US49.40/t.

Cost estimates are a moving feast because all miners are working hard to cut costs as the price falls. Fortescue, for example, is tipped to get its all-in cost down to $US65.80/t by the end of next year, according to Credit Suisse.

Day-to-day costs and prices are just part of the emerging iron ore situation and while crucially important there are other factors are work, such as mine-site accidents and management disputes.

Neither Mount Gibson nor Rio Tinto could probably do much to avoid what happened at their operations.

Fortescue, however, could certainly do something about keeping the market more clearly informed about its future direction and whether it is a pure iron ore play, or a company considering a significant change of direction at an extremely difficult time.

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